Sunday, January 11, 2009

Thoughts on regulating the CDS market

I've received a few requests for my thoughts on various forms of regulation for the CDS market. When I was working on credit default swaps in the first half of this decade, during the big push to standardize CDS contracts, I never in my wildest dreams thought that CDS would become a popular topic of discussion, or that anyone outside the world of structured finance law would ever willingly ask me to discuss CDS! First of all, I think it's very clear that the current regulatory posture—that is, an unregulated dealer-driven OTC market—is not a viable option anymore. CDS are way too important to remain unregulated. CDS can be structured to mimic so many other financial instruments that they simply cannot exist in the shadows anymore. In addition to their traditional role of hedging credit risk on corporate bonds, CDS are now used: as stand-alone synthetic trades; in synthetic CDOs; to hedge credit risk on ABS or CDOs; to take long/short positions on indexes of U.S. or European corporate bonds (CDX.NA.IG, iTraxx Crossover, etc.); to hedge region-specific macroeconomic risks (via baskets of sovereign CDS); and so on. I don't think CDS have been a major contributor to the financial meltdown, despite the media's wild accusations, which are driven largely by the combination of huge (though completely irrelevant) numbers like $62 trillion(!), and the media's sheer ignorance of CDS. Felix Salmon has been a notable exception, and has done a terrific job explaining CDS in simple terms—much better than I ever could have done, as I definitely don't have that particular gift. Alas, not everyone reads Salmon's blog, so misperceptions about CDS remain widespread in the media (memo to the New York Times: hire Salmon as a financial reporter and fire the incompetent Gretchen Morgenson—immediately). To be perfectly honest, sometimes I think Salmon has been a little too sanguine on CDS, such as when he dismissed concerns about counterparty risk, saying that it was "something the banks were pretty much on top of all along, and so far it hasn't been a big deal." In reality, counterparty risk has been a huge deal in the CDS market since Bear collapsed; for example, a Greenwich Association survey from August found that over 75% of institutions agreed that "counterparty risk in credit default swaps represents a serious threat to global financial markets." Counterparty risk in the CDS market isn't a huge deal relative to other problems in the financial sector, but it's still a very real problem that needs to be addressed. Regardless of whether CDS have actually been a source of systemic risk, there's no doubt that the CDS market is big enough to be a source of systemic risk, and that in itself justifies some level of government oversight. We can't rely on the International Swaps and Derivatives Association (ISDA) to regulate CDS, nor should we. The ISDA is dominated by the major dealers—JPMorgan, BofA, UBS, Deutsche Bank, Goldman, Morgan Stanley, Citi, and Credit Suisse. The ISDA is interested in a CDS market that's safe for the dealer banks, yet also remains a dealer-dominated market. Because the dealers usually carry matched books—that is, they hedge all the CDS positions, for example by offsetting each CDS they sell by buying the exact same CDS from another counterparty. So it's fair to say that the ISDA isn't terribly interested in where all that risk ends up, just as long as it doesn't end up with the dealer banks. As it turns out, most of the risk is concentrated in AIG and the monolines. Of course, this was widely known in the CDS market for years, but the ISDA never tried very hard to do anything about these dangerous risk concentrations because the dealers needed AIG and the monolines for liquidity—especially for CDS on ABS and CDOs, and for bespoke CDS, where the dealers' fees are substantial. Don't get me wrong, the ISDA is a fine organization, and it's done yeoman's work negotiating and implementing improved contractual terms for CDS. But the ISDA is not a substitute for a regulator. And no matter how hard it tries to keep the CDS market unregulated, the ISDA can't get the genie back in the bottle this time. One potential solution is a central clearinghouse. A clearinghouse is the counterparty to every trade, thus eliminating counterparty risk. Counterparty risk was acute in the aftermath of Lehman's bankruptcy, since it was one of the major CDS dealers. Right now, there are four companies racing to set up a clearinghouse: IntercontinentalExchange (ICE), CME Group, NYSE Euronext, and Eurex. The dealer banks are backing ICE, so it's widely expected to be the dominant clearinghouse. However, I'm not convinced that a central clearinghouse will end up working. For one thing, a clearinghouse would only clear standardized trades. That's all well and good, but a large segment of the CDS market is bespoke. This is especially true for CDS on ABS and CDOs, as the terms of these CDS are tailored to the specific form of the underlying structured security. It took a while for the market to even settle on the standard template for CDS on ABS and CDOs—the ISDA introduced the standard pay-as-you-go template in June 2005 (the template is known, inexplicably and over my strong objections, as PAUG, rather than PAYGO). But even with a standard PAUG template, the terms of these CDS aren't standardized in the sense that each CDS on ABS isn't the same. There are important toggles within the PAUG template—for instance, the treatment of an interest shortfall depends on whether the contract uses the "no cap," "variable cap," or "fixed cap" toggle. And of course, the underlying structured securities are often significantly different, with material terms such as attachment and detachment points running the gamut. There's no way a clearinghouse would clear CDS on ABS or CDOs—in fact, CME already said it won't clear CDS on MBS or sovereigns—so this entire market would be unaffected by the introduction of a central clearinghouse. Even single-name CDS are often bespoke. For example, the Threshold and Minimum Transfer Amount, which are important in terms of when collateral must be paid, can differ substantially (I can't even count all the different combinations of Thresholds and MTAs I've seen). How much of the existing bespoke single-name CDS would migrate onto a central clearinghouse? It's not entirely clear. Also, it's not clear from the ICE proposal that all parties would be able to face the clearinghouse. It's complicated, but sometimes clearinghouses are structured so that non-members can't face the clearinghouse, but instead must transact with a clearinghouse member, with the clearinghouse simply guaranteeing payment if a member defaults. I hear that this is what ICE is trying to do. Essentially, ICE is trying to keep the structure of the current OTC market, only now with a central clearinghouse to guarantee all the major counterparties. I'm not sure the New York Fed will approve that proposal. The New York Fed already rejected ICE's first proposal, which included a provision allowing the major dealers to form a committee that would have had final authority over which contracts would be cleared. If the dealers aren't willing to let everyone face the clearinghouse, or they're not willing to let the clearinghouse be governed independently, then I don't see how ICE can get approval to set up a clearinghouse. A lot depends on the initial margin that the clearinghouse requires. The dealers will likely try to undercut CME et al. on initial margin to attract more liquidity, but if ICE Trust (the name of the proposed clearinghouse) is governed independently from the dealers, then they may not be able to keep the initial margin low enough to maintain the level of liquidity that has made the CDS market so attractive. The initial margin requirements that the clearinghouses have been throwing around sound pretty onerous to me—high enough that liquidity would be seriously impaired. If that ends up being the case, will the major dealers try to keep most of the CDS market off the clearinghouses and flowing through them instead? Without the major dealers, of course, a central clearinghouse solution won't work. Best-case scenario, I can see one clearinghouse for standardized single-name corporate CDS, the CDX indexes, and the iTraxx indexes. If that clearinghouse is ICE, then those trades will continue to be highly liquid. If that clearinghouse is CME, NYSE Euronext, or Eurex, or even all three, then it's unclear how much of that market would flow through the clearinghouse and how much would remain with the dealers.


ABCrespin said...

Nice article! How do you think the launch of the ISDA Big Bang Protocol and Auction Supplement will affect settlement risk in the CDS market in total (dealer banks and dealers)? I've heard that at least 2054 parties have adhered to the protocol so it should not only be the dealer banks participating to ISDA's initiative. And how about the risks involved in the settlement of the restructuring credit events? These risks are not covered by the ISDA protocol.. What is your view on this type of settlement risk that remains uncovered?

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