Contrary to the impression given by some, a central clearing house for credit default swaps (CDSs) is not a cure-all for the perceived problems in the credit derivatives market. For a start, a central clearing house will not eliminate counterparty credit risk - instead, it will concentrate it within a single institution. True, a clearing house has never collapsed, and the major players point out they had more than enough resources at their disposal to withstand the collapse of Lehman Brothers last September. But if the events of the past 18 months have taught us anything, it is the need to consider and be prepared for worst-case outcomes.
There is also some question over whether it will be feasible to clear anything other than the most straightforward index trades. Some participants have claimed that margin requirements on single-name CDS transactions will be onerous, particularly for less liquid names - meaning it may not be economical to clear a huge proportion of the market. Yet if regulators push for the mandatory central clearing of all credit derivatives (which, even given the sabre rattling by the European Commission (EC), seems unlikely), a huge swath of the CDS market could disappear at a stroke.
On top of that, the supervisory structure appears, to put it kindly, confused. Those groups planning to launch clearing platforms in the US have had to obtain regulatory approval from a variety of supervisors - in some cases, from all three of the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission. It would seem at least possible there will be some confusion over the duties and responsibilities of the respective regulators. Meanwhile, the EC's insistence on the launch of a clearing house in Europe seems unwarranted given the global nature of credit derivatives trading.
That's not to say there will be no benefit from the establishment of clearing services. It should bring greater transparency to the credit derivatives market - surely a good thing. But let's not forget the CDS market actually held up relatively well during an unprecedented period of stress at the end of last year. The cash settlement auction process was thoroughly tested after a succession of large, complex credit events. Despite one or two technical problems, particularly around the recovery values of senior and subordinated obligations issued by Fannie Mae and Freddie Mac, the instruments worked as they were supposed to and protection buyers received their payouts. Central clearing is certainly to be welcomed - but it is by no means a panacea.Nick Sawyer, Editor.