TABB Group Report Pinpoints Misconceptions vs. Reality in CDS Market

TABB Group released a report today on credit default swaps and the current state of major central clearing initiatives that also discusses the misconceptions vs. reality surrounding this market on the part of legislators seeking more oversight.

According to TABB’s report, misconceptions regarding the utility and purpose of CDS continue to spread and the financial industry’s efforts to defend these instruments have been met with disdain by legislators seeking oversight of the CDS market through misguided regulatory efforts.

The report’s author, Kevin McPartland, senior analyst at TABB Group, points out that the CDS market generated heated debate even prior to Wall Street’s financial crisis as the focus shifted from reducing the confirmation backlogs to a central counterparty clearing (CCP) model and more recently, to the possibility of requiring these OTC (over the counter) products to trade on an exchange.

McPartland finds there is unfair treatment of these CDS instruments during the financial crisis, discusses how this market segment will continue to expand and pinpoints issues to watch, such as CDS market transparency, mandates and electronic trading.

Although the CDS market will continue to expand and grow, the outstanding notional value of the CDS market has declined dramatically largely due to trade compression. The report estimates that CDS market revenues from central clearing, electronic trading and existing trade migration will grow to $174 million, increasing at a 12 percent CAGR (compound annual growth rate) through 2011.

A new regulatory structure including central clearing and electronic trading will streamline the market, lower barriers to entry for buy-side firms and ultimately increase volumes, says the study’s author, according to today’s release. "However, beyond the ubiquitous counterparty risk issue, concerns over operational efficiency issues continue to plague the CDS market at the same time that global regulators are pushign the industry to adopt central clearing for CDS trades and increase market transparency," stated McPartland in the release.

One of the misconceptions, McPartland clarifies in the report is that the four proposed major initiatives from CME/Citadel, NYSE Euronext, Eurex and ICE (which includes Creditex and TCC), each vying to be the central counterparty of choice for the CDS market, will allow trades into their clearing houses from nearly any execution platform, including those operated by their competition. However, even when the first central clearing entity goes online, a number of challenges will remain that require further thought and innovation, according to the release, summarizing the report.

Looking ahead, the report identifies issues to watch in the years ahead including: CDS market transparency, mandates and electronic trading. The report also comes with nine detailed charts: CDS market size through 2011; CDS holdings by institution type; CDS confirmation backlog levels; total notional value of CDS novations; comparison of CDS central counterparty solutions; potential global CDS market revenue from central clearing; electronic trading and trade migration; CDS holdings by underlying; settlement period and CCP use by product type; and OTC derivative market size by type.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio