In new research published today, Tabb Group says the majority of credit default swaps (CDS) products blamed for adding significant systemic risk to the global financial markets will never be centrally cleared in the United States and Europe.
According to the report's authors, Larry Tabb, founder and CEO, and Robert Iati, partner, global head of consulting, "Central clearing is undergoing considerable change brought on by the domino-like impact of the sub-prime mortgage crisis, the loss of major firms, the seizing of credit markets and the bailout of major banks - challenges exerting pressure on industry participants and regulators to develop a better clearing model." Unfortunately, the continuing credit crisis puts the bank community, already disadvantaged by CDS clearing issues, in a vulnerable position with diminished negotiating power to ward off regulators seeking to lower banks' risk profiles and reduce their balance sheets.
The report, "Global Credit Default Swap Clearing: Getting the Model Right," focuses on the most difficult clearing challenges, specifically those required to clear over-the-counter (OTC) CDS contracts. It examines the mechanics of derivatives central clearing, as well as challenges of ownership, regulation, valuation, risk management and various CDS central clearing models proposed by major central counterparties (CCPs). It also pinpoints over 20 open issues requiring industry solutions.
Recent exposure to risk in the derivatives markets has fueled the call for the financial industry to mandate central clearing of derivative products, CDS in particular. However, the authors explain, while clearing securities is fairly straightforward, CDS clearing is not, because CDS agreements can be outstanding for years and need to be risk-managed daily. "CDS clearing is more about managing risk, margin and workflow than transferring securities title and facilitating payment," says Tabb. "The clearing of CDS is not all homogenous and has different complexity levels. Index-based CDS clearing is much more straightforward than clearing single-name CDS or CDS tranche products. We believe the most significant CDS clearing challenges come from five major issues: product complexity, valuation, liquidity, interoperability and counterparty-risk."
One of the challenges with CDS clearing is simply the global nature of CDS. "Most clearinghouses are local, as members, products and regulators typically are regulated nationally," says Iati. "For clearing of over-the-counter products to succeed, all of the participants must adopt standard contract language, structure, trade matching, affirmation and communication timeframes. But one of the primary challenges for effective global OTC trade clearance is the lack of consistent access to clearing corporations by potential participants, because scale and critical mass maximize the value of clearing."
CDS clearinghouses, which generally provide five major services - comparison, trade guarantee, novation, margin management and netting/compression - strive to reduce risk, increase operational efficiency and honor members' obligations when counterparties fail. When markets are running smoothly, most members focus on the operational benefits of clearinghouses from streamlined workflows, reduced credit vetting and increased credit lines. "But this is only part of the value," says Iati. "The real benefits are realized when things go wrong - really wrong. Without central counterparties, the insolvency of a single organization could impact the entire financial system with one organization's problems having a deleterious impact on their trading partners, creating a domino effect across the market."
TABB Group believes there will be CDS CCPs in the US and Europe for CDS agreements. Dollar-denominated products will most likely be cleared in a US-based and regulated entity and Euro-based products will be cleared in a European platform. "The larger question, though, revolves around what happens to the Euro-platform," says Tabb. "Will there be one platform for Eurozone only and another for European non-Eurozone members? Will the platform be London-based, offered through players such as NYSE Euronext bClear or ICE Clear Europe or will flow consolidate to a more continental platform such as Eurex?"
The need for competition in the CDS clearing space, Iati writes, is being driven by six factors: opportunity, jurisdictional squabbles, cost, multiple CDS products, risk mitigation and dealers do not want to put all of their eggs in one basket - at least at this time. "CCP competition is possible, yet competition in the CDS clearing space is fraught with complexity, due to the heterogeneity of national, fiscal, legal and regulatory structures of the individual markets and the varied economic interests of market participants."
While a single clearing infrastructure is possible, the clearing arena needs only enough competition to provide a sound environment that fosters innovation and provides the efficiencies and services required of the changing market place.
However, for Tabb and Iati, the question is, "what constitutes enough?" The possibility of a single-clearing provider for CDS is extremely remote and the authors believe that without the appropriate governance that prevents the risks associated with a monopoly, a single CCP would actually be an unhealthy outcome. "This market needs both competition and flexibility in order to accommodate its diversity," says Tabb. "If one is too few, then three is probably the practical limit before interoperability tips clearing into the red zone of complexity and creates an imbalance between operating costs and commercial viability. If nothing else, should there ever be another issue the size of Lehman to unwind, it needs to be handled quickly and smoothly."