The credit default swap market is viable but stressed, and its opacity continues to be a threat to itself and to the economy. There is broad agreement that greater transparency could be achieved through a dedicated clearing house, but the earliest it will be up and running is late July, and that is too long to wait.
It is time for the regulators to assert themselves and tell market participants to start clearing credit default swaps — or CDS — now. Too many financial institutions look too shaky, and lifting the veil of institutions' exposure could help avert another meltdown.
Once clearing is established, then regulators and participants should move the bulk of these products — believed to be tens-of-trillions of dollars' worth — into exchange-based trading and true price transparency as quickly as possible. The more customized credit default swaps would be monitored in a newly well-regulated, over-the-counter market.
The breakdown of the securitization market had as much to do with its opacity as anything else. The unclear ownership trail of all those pieces of subprime (and prime) mortgages and other loans that were rearranged in asset-backed securities turned such holdings toxic. Similarly, the murkiness of counterparty risk in the unregulated CDS market threatened the financial system after the failure of Lehman Brothers, and compelled the rescue of AIG.
Last year, the Federal Reserve Bank of New York, the European Union and the major players in the CDS market agreed to have a clearing house operation in place by Dec. 31. It never happened. In February, six of the biggest CDS market participants finally agreed to use an EU-based clearing house by the end of July, only after EU Finance Commissioner Charlie McGreevy put legislation in motion to mandate clearing.
Why the delay, when there's no technical impediment to clearing or exchange-based trading? The prevailing wisdom is that the major players — and it's not even clear who some are — prefer the status quo because it ensures their dominance.
With CDS, a buyer pays premiums to the seller for an instrument that provides protection if the insured derivative financial instrument defaults. But while the concept may be simple — think of it as insurance — the market itself is shrouded in fog. Sellers don't have to be regulated, and buyers don't have to own an underlying instrument or have any credit exposure at all. The swaps fall under mark-to-market accounting practices.
The notional value of CDS has swollen from less than $50 billion in early 1997 to $56.4 trillion in mid-2008, according to the International Derivatives and Swaps Association (IDSA), down from $62.2 trillion at the end of 2007.
In November, DTCC Deriv/SERV, a service provider for the derivatives market, started posting on its Web site weekly gross notional values of CDS registered for the largest entities in its Trade Information Warehouse. A week later, DTCC started publishing data related to weekly confirmed volume. And in January it added weekly trading activity, including new trades.
That's still not enough transparency. Robert E. Litan, senior fellow of economic studies at the Brookings Institution, says the notional value of CDS isn't a "real measure of exposure. That's the face value of insurance contracts."
And as for clearing being a panacea, Craig Pirrong, professor of finance at Bauer College of Business at the University of Houston, notes that simply "having a warehouse of deals, with better post-trade transparency, and better confirmation," is enough. Pirrong acknowledges the efficiency of exchange-based pricing, but also points to problems with standardizing CDS.
Yet the enormous size of the CDS market demands regulatory oversight and genuine transparency to protect against systemic risk. This market has grown too big for its OTC britches. "We'll see clearing houses," says Viral V. Acharya, professor of finance at New York University, "but an exchange brings the greatest clarity. And CDS volume certainly could support exchange-based contracts."
Should governments intervene? "In good times, the position of regulators is not very strong," says Acharya. "Regulators have a great deal of leverage right now over the private sector,"
Despite the failure of Lehman Brothers, and in the face of the slow and expensive unwinding of AIG at U.S taxpayer expense, the CDS market remains intact.
But could the "temporary receivership" of a top-10 U.S. bank undermine CDS integrity? What percentage of these swaps underwrites East European instruments? With all this uncertainty, clearing needs to begin sooner rather than later, and exchange-traded CDS must follow quickly.
It's time for this vulnerable market to take its vaccine.