Proposals to reduce risk in the trading of credit default swaps through the introduction of central counterparty clearing are badly flawed, according to research conducted at the Stanford Graduate School of Business.
In a preliminary research paper, Darrell Duffie, professor of finance at GSB, and doctoral student Haoxiang Zhu, conclude that the central clearing houses founded to rationalize the $27 trillion market for credit default swaps will not remove nearly as much risk as regulators might hope.
The paper purports to demonstrate that adding a CCP for one class of derivatives can actually reduce netting efficiency and lead to an increase in collateral demands and average exposure to counterparty default. What's more, say the researchers, the introduction of multiple competing counterparties can exacerbate the problems.
Responding to pressure from regulators, dealers in Europe and the US, agreed to the establishment of CCP infrastructure for the CDS marketplace, and by early spring two had been opened and more are planned. Similar moves are afoot in Asia, where the Japan Securities Clearing Corporation and the Tokyo Financial Exchange are working out details on infrastructure investment, fees and overseas co-operation, following a six-month deliberation on the introduction of CCP clearing for OTC interest rate swaps and CDS deals.
Duffie, a member of the Financial Advisory Roundtable of the New York Federal Reserve Bank, supported the establishment of a clearing house in testimony last year to the US Senate Committee on Banking, Housing, and Urban Affairs. He still supports that idea, but maintains that the current implementation is flawed in several respects.
Although the worldwide market for credit default swaps is huge at $27 trillion, it has shrunk by more than 50% in the past year, and is too small - and the number of participating institutions is too small - for a clearing house that deals only in CDS to efficiently reduce counterparty risk, says Duffie.
Instead, Duffie and Zhu suggest that the clearing house should clear a much larger fraction of trades made in the $500 trillion market for over-the-counter (off-exchange) derivatives.
"Our results make it clear that regulators and dealers should carefully consider the tradeoffs involved in carving out a particular class of derivatives, such as credit default swaps, for clearing," the research paper states.
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