Centralized Clearing and Counterparty Risk for the CDS Market

The establishment of exchanges and centralized clearing for the CDS market may not necessarily be a panacea for risk, according to Darrell Duffie, professor of finance at the Stanford Graduate School of Business. Duffie argues that the clearing platforms that have been launched to rationalize the CDS market will not remove nearly as much risk as regulators hope.

Duffie, a member of the Financial Advisory Roundtable of the New York Federal Reserve Bank, supported the establishment of a clearinghouse in testimony last year to the US Senate Committee on Banking, Housing, and Urban Affairs. He is still in favor of that idea, but maintains that the current implementation is flawed in several respects:

• Although the worldwide market for CDSs is huge, it has shrunk by more than 50% in the past year. A clearinghouse dealing only in CDSs is now too small to efficiently reduce counterparty risk in the entire financial system. Instead, Duffie suggests that the clearinghouse should clear a much larger proportion of trades made in the market for all OTC derivatives, not just CDSs.
• CDS clearing will merely net out exposures between counterparties with regard to their CDS positions alone—ignoring all other exposures. Oddly enough, this may lead to cases where aggregate systemic risk is increased rather than mitigated. For instance, in the old OTC-cleared world, if Dealer A is exposed to Dealer B by $100 million on CDSs, while Dealer B is exposed to Dealer A by $150 million on interest rate swaps, then the two dealers would, under their ISDA Master Agreement protocols, net out their exposure, leading to a flat $50 million in risk taken by Dealer A. However, if the two counterparties clear their trades through ICE Trust, for instance, there would be no netting of aggregate positions. Dealer A would be taking on exposure to Dealer B of $150 million—or $100 million more.
• Multiple clearinghouses in the global market will make matters worse. Having more than one reduces the netting effect even more; each additional clearinghouse exacerbates the problem.
• Transparency will not necessarily improve with centralized clearing. Presently, the same level of information about CDS trades that would be available to regulators in a clearinghouse is already available through the DTCC website. With or without a clearinghouse, so far there is no plan to reveal all trades, all pricing, and all limit orders to the public. “I’m sorry to disappoint, but most of the information about default swaps remains confidential even when cleared,” Duffie says.

Had a system of centralized clearing been up, running, and liquid five years ago, the US taxpayer might still have been forced to bail out AIG. Almost all AIG trades were highly customized to a unique pool of reference entities. These types of customized CDSs would still have been OTC cleared, rather than ICE or CME cleared. They would still have been entirely opaque, and would still have exposed the market to an enormous amount of systemic risk. In other words, a centralized clearing system may do nothing to prevent the next AIG.

–Theodore J. Kim, Esq., CFA, FRM, is a New York-based managing director of Smart Cube, an independent global research firm focused on capital markets and investment management.

This article was originally published as a companion piece to "Controlled Dangerous Substances: The CDS Market Goes Straight," which appeared in the Summer 2009 issue of the Investment Professional.