The collapses of Lehman Brothers and Bear Stearns raised an alarm with regulators, who feared that the interdependency of the dealers' large credit default swap books would expose the global financial system to systemic risk. Now regulators are driving change in the credit derivatives market to stem the counterparty risk faced by long-only asset managers and hedge funds in their transactions with the top dealers. After years of resisting changes to the bilateral over-the-counter market structure, major credit derivatives dealers have agreed to mandatory clearing of credit default swaps to ward off a more radical plan to move CDS trading onto an exchange, according to reports published in November.
While dealers have kept control over the trading of CDSs -- insurance contracts that are used to protect against a debt issuer defaulting -- for now, the complexity of these instruments and the role they played in the financial crisis have made it seemingly inevitable that the dealers will face increased regulation.
"The credit default swap market is not going away," says Jamie Cawley, CEO of IDX Capital, an electronic interdealer-broker (IDB) that matches trades between the big dealers in the wholesale market and is looking to offer an electronic platform for trading credit derivatives that is open to the buy side. "It's evolving into something more stable -- something that should have been done five to seven years ago."
In Cawley's vision the credit derivatives market will undergo a transformation: The market structure "will be flattened" by the creation of multiple clearinghouses and execution platforms, he says, which will disintermediate the traditional voice brokers in the IDB space and squeeze out some intermediaries.
For now regulators' priority is to push for the establishment of a central clearinghouse facility. There are at least four initiatives in progress to set up a central clearinghouse, including efforts headed by the Intercontinental Exchange, CME Group, NYSE Euronext Liffe and Eurex. CME Group's proposed CME Clearing House for derivatives is the only one that includes both a clearinghouse and an electronic execution platform.
To satisfy the regulatory demands for central clearing but keep CDS trading in an OTC market structure, many dealers reportedly support the initiative put forth by the Intercontinental Exchange. One source suggests that ICE has taken the short-term lead with its acquisitions of Chicago-based Clearing Corp. (CCorp); Creditex, an IDB with an electronic matching platform for CDSs; and T-Zero, a trade affirmation system used by the major dealers and buy-side firms.
But how far will the market structure changes go, and what will be the future of trading credit default swaps and the related CDS indices? Will trading in the opaque, virtually unregulated derivatives market -- which currently has a notional value of approximately $33 trillion but has reached a value as high as $70 trillion -- end up on exchanges with transparent public pricing, continuous netting and trade reporting? >>
"There's definitely the pressure for greater transparency, and the regulators are pushing things to be more electronic," says Kevin McPartland, senior analyst at TABB Group. The main focus in 2009, however, will be on the clearinghouses, he predicts. "Once that ball starts rolling, the next ball will roll to electronic execution," he adds. "If the trades can be executed and negotiated electronically, that will streamline things."
So far, three potential models for electronic CDS trading are emerging: First there is the exchange model linked to clearinghouses; then there is the dealer-to-institutional client model, which is clearinghouse-agnostic; and finally there is the potential for a direct buy side-to-buy side execution platform. Many industry sources, however, expect CDS trading ultimately to move onto exchanges.
"The entire model of large risk taking by the dealer community is under question," warns Sasha Rozenberg, product manager of derivatives at SuperDerivatives, a supplier of OTC derivatives trading technology. "There are several aspects -- from regulatory pressure to huge losses, to general scares about derivatives -- that are forcing dealers to agree to have derivatives move onto the exchanges."