Regulating Credit Default Swaps: Will It Work?

Even after one or more clearinghouses emerge, there's still likely to be a thriving over-the-counter market because derivatives resist standardization

By David Bogoslaw

The market for credit default swaps (CDS)—derivatives that insure holders against default on a range of debt instruments—is getting plenty of attention from regulators and finance industry officials. The Federal Reserve and other regulatory bodies are targeting the end of 2008 to have one or more clearing platforms for CDS trades in place. That's no guarantee, however, that a significant portion of an estimated $47 trillion worth of the contracts, which largely originated in the over-the-counter market and are not standardized, will end up migrating to a more transparent trading environment.

While prior efforts to move credit derivatives to exchanges haven't succeeded, the odds are currently much better, given the regulatory spotlight and upheaval in the financial markets, says Andy Nybo, senior analyst at the TABB Group, a research and strategic advisory firm focused on capital markets. The only way to ensure these contracts trade on an exchange is by regulatory mandate, he adds.

The central role that speculation in the unregulated CDS market played in the bankruptcy of Lehman Brothers Holdings and the government takeover of insurance behemoth American International Group (ICE) has U.S. regulators pushing for increased oversight. The Federal Reserve Bank of New York and the Securities & Exchange Commission are asking that information about CDS contracts that diverge from standard terms be disclosed to a "warehouse" that would record all trades, Bloomberg News reported on Nov. 19.

Investors Still Trying to Hedge

Although the credit markets remain virtually frozen, with barely a trickle of new corporate debt being issued, that hasn't slowed demand for or access to credit default swaps written against that debt. In fact, some people think that CDS have gotten a bum rap along with other "financial derivatives of mass destruction"—Warren Buffett's oft-cited criticism of the instruments—and that regulators' time would be better spent on markets that continue to be dysfunctional, such as securitized products.

First, there are still lots of investors trying to hedge their exposure to an enormous supply of corporate and sovereign debt that is currently outstanding, according to Nybo. That means that new CDS contracts can be written even without new bond issues, he says. CDS also serve as a form of leverage for investors who don't have debt positions to hedge but want to take directional bets on credit spreads either widening or narrowing.

Although transparency and risk reduction are the two mantras driving regulators' aggressive push for a centralized platform to clear CDS trades, an equally important goal is to compress trades by "tearing up" redundant transactions that dealers did to protect themselves against unknown counterparty risk, says Jeffrey Hogan, senior managing director at BGC Partners (BGCP), an interdealer securities broker. The redundant trades tied up capital, which dealers felt they needed to reserve for potential payouts on CDS they had sold. "For a given amount of capital, a dealer can do more transactions because they all [trades are guaranteed by a single counterparty]," says Hogan. "Central clearing will result in higher velocity of transactions in those [CDS] products," both for indexed and individual bonds.

Tearing Up Overlapping Trades

Elimination of redundant trades to free up banks' and other dealers' capital may be one aim of regulators, but that's been occurring even without a central clearinghouse for credit derivatives, mostly due to the efforts of the New York Federal Reserve Bank since 2005, says Greg Zerzan, counsel and head of global public policy at the International Swaps & Derivatives Assn. "The credit crisis has clearly speeded up the timetable for implementing some of these measures like the clearinghouse," he says. "Firms are committed to sitting down with their counterparties and reviewing their outstanding positions, making sure they are valuing their positions the same way and tearing up trades that overlap."

Setting up a central clearing mechanism will work only if CDS contracts have been sufficiently standardized so that they can trade efficiently on such a platform. The ISDA has already done a lot to lay the groundwork for standardized contracts, including setting up various protocols that market participants can sign onto, says Joseph Mason, professor of finance at Louisiana State University's E.J. Ourso College of Business. Standardizing contracts for trading on an exchange really comes down to all the gory little details, such as stipulating that a corn futures contract on the Chicago Mercantile Exchange represent 5,000 bushels of No. 2 yellow corn, he says.