Discussions on the establishment of a central clearing house for derivatives products have taken place at various stages in the past 20 years. And with concerns heightening over counterparty risk in the wake of the Bear Stearns collapse, dealers are again contemplating a central clearing house initiative, focused on credit default swaps (CDSs).
Several dealers, brokers and other participants have in recent months been locked in discussions with the Clearing Corporation, the Chicago-based clearing house in which many of Wall Street’s leading names are shareholders.
One problem that emerged recently is that some participants in the credit derivatives market have not been fully aware of the true extent of their counterparty risk exposures. The basic premise of the initiative is to create a framework whereby participants would deal with a single counterparty – the clearing house. By shifting the focus from gross exposures to net exposures, those involved hope the move will remove complexity from the financial system that some observers believe has been a contributing factor to recent turmoil.
“There is not one element that is going to solve all the problems, but it is one piece of the puzzle that will help us create a more robust framework. The timing is right – whether it will be successful or not, only time will show,” said Athanassios Diplas, chief risk officer and deputy chief operating officer of the global credit business at Deutsche Bank, speaking at Isda’s twenty-third annual general meeting in Vienna on April 17.
The initial focus of those involved in the discussions has been on index products, because they are fungible. Over time, efforts will extend to single-name CDSs. According to Diplas, this will remove risk from the system and the worry that the failure of one dealer could cause a hazardous shock in the market.
No details were given on a time frame for when a central clearing house would be established, but Diplas said the admission criteria for participants would be strict. “The criteria will take into account how well capitalised the firm is, how the risk is dealt with, how the variation margins are going to be posted and what the expected gap risk is going to be. All these issues have to be dealt with carefully – we are not going to be jump into something unless we are very confident it will work.”
Not all market participants are convinced a central clearing house is what the market needs. Tom Jasper, chief executive of credit derivatives product company Primus Guaranty and the first chairman of Isda, has been privy to many discussions on a central clearing house over the years and admits he is sceptical about such a move.
“I understand the rationale for why the industry is looking at it, but the industry has to really understand what the problem we are trying to solve is,” he said. “We don’t want to impose on the market a clearing house structure that by definition is going to take away some of the vestiges of the over-the-counter aspects we have done a very good job of encouraging the development of over many years.”
Diplas, however, disputed the idea that a central clearing house would move the industry away from being an OTC business. “This will help participants to clear particular products, but we want to maintain the OTC nature of the product: that is what clients want and what has been behind the success of the business. We do not want to damage this in any shape or form,” he insisted.
Additionally, Diplas said it was important to note that a central clearing house would only help mitigate systemic risk, not idiosyncratic risk. The new framework would not save dealers that put on bad trades.