Why It's Important: The demise of Bear Stearns and Lehman Brothers, as well as the bailout of AIG, exposed hedge funds and insurance companies to counterparty risk from dealers on the other side of their credit default swap (CDS) trades. When Lehman failed, triggering a credit event, it defaulted on its CDS payments. "Most of the concern lies with people who were in bilateral contracts with Lehman Brothers and were left with open exposure," comments Kevin McPartland, senior analyst at TABB Group. Because these instruments are cleared through the dealers, which all are interconnected, the enormous size of the CDS market -- notionally valued at $55 trillion -- triggered worries about a financial meltdown. Since the CDS market is over-the-counter and lacks transparency, regulators couldn't see which dealers had traded what and with whom.
Where the Industry Is Now: A group of major CDS dealers have agreed to participate in a central clearinghouse for credit derivatives and to accept oversight from the SEC to ward off a more radical plan that would force CDS trading onto an exchange. Regulators are fast-tracking the legal structure to get the clearinghouses up and running before 2009. Four entities are vying to create a central clearing counterparty (CCP) or regional clearinghouse model. However, what form this will take is still up in the air. According to McPartland, there could be a global CCP for all CDS transactions, a single CCP for each major world market (i.e., Europe, the U.S. and Asia), or multiple venues across regions (both globally and regionally focused).
Focus in 2009: Dealers will work with regulators throughout 2009. A key focus will be on increasing transparency since the clearinghouses will become warehouses for real-time trade data. "The goal here is for regulators to get at information as a major source of risk for banks that issued these securities," explains Eric Bass, senior managing director for SMART's financial services industry business consulting services practice. Sources say regulators won't endorse any one central clearing solution but are more apt to foster competition among the various entrants.
Industry Leaders: Of the four potential central clearing providers, the Intercontinental Exchange -- through its acquisition of Chicago Clearing Corp. (CCorp) and its interdealer-broker Creditex and STP technology arm T-Zero -- is viewed as a front-runner. But futures exchange operator CME Group is working with Citadel Investment Group to create an exchange-like platform to trade and clear CDSs. NYSE Euronext (through Liffe) and Eurex are emerging as the major players in Europe. And Knight Capital Group has announced NetDelta, a settlement platform that is positioned as an alternative to a CDS clearinghouse.
Technology Providers: The CDS clearinghouses are supplying their own technology. "All of these players are established exchanges with clearing technology already," observes McPartland. ICE has access to CCorp's matching and clearing facility. CME Clearinghouse is already established and only needs to make incremental enhancements, according to Kim Taylor, managing director and president, CME Clearing. Similarly NYSE Euronext Liffe has a platform (BClear) that already is used to clear OTC derivatives. Dealers will work with third-party technology vendors such as Omgeo to connect with the CDS clearing platforms, notes SMART's Bass.
Price Tag: The industry will bear the brunt of the central clearing costs, which include setting up a default fund. Start-up clearinghouse efforts could cost $1 billion to $3 billion and run as high as $6 billion, contends CME's Taylor, who contrasts this with CME's lower costs since it already has an existing clearinghouse for futures. "The incremental investment that we need to make in order to do credit default swaps is not that large," says Taylor.