Risk Professional, February 2009

r e G u l a t i o n By Katherine Heires

Too Much of a Good Thing

Will well-intentioned controls kill the credit swap?

imothy Geithner, the new U.S. Treasury secretary who was then president of the Federal Reserve Bank of New York, in September 2005 sounded an alarm on credit default swaps. Concerned about counterparty risk, he called a meeting of top Wall Street executives and insisted they adopt new systems and procedures to clear away a mounting backlog of unconfirmed CDS trades.

The financial community responded; by mid-2008, 95 percent of over-the-counter credit derivatives transactions were being confirmed electronically within New York’s Depository Trust and Clearing Corp. But systemic risks hardly abated as the notional value of outstanding credit derivatives had soared from $17 trillion at the time of Geithner’s warning to $55 trillion (which was down from a peak of $62 trillion at the end of 2007), according to the International Swaps and Derivatives Association. Those concerns only escalated as the financial crisis deepened.

Industry advocates have defended the derivatives’ constructive risk management and hedging functions. Robert Claassen, head of the derivatives group at New York law firm Paul Hastings, says that “by purchasing CDS, you are taking risk off of your balance sheet.”

DTCC has noted that less than 1 percent of CDS contracts registered in its Trade Information Warehouse related to residential mortgage-backed securities. Yet legislators were not quieted: Sen. Tom Harkin, Democrat of Iowa, called credit derivatives a “ticking time bomb,” and Rep. Barney Frank, Dem-

ocrat of Massachusetts, deemed them a primary cause of the crisis.

One measure addressing such concerns and encouraged by regulators is central counterparty clearing, in which a clearing house bears the risk of a trade failure. CCP clearing is crucial not only to avoiding systemic breakdowns, but also to the transparency and efficiency of options and futures exchanges. But exchange-traded instruments are by definition and necessity standardized,

while OTC derivatives are not, for their own good reasons, and there are those who don’t want this baby disposed with the bathwater. As standardization increases, flexibility and innovation decline, warns Christopher Zingo, a senior vice president at derivatives pricing system operator SuperDerivatives in New York. “You cannot manage all the permutations of an OTC marketplace in a central clearing environment,” he says.

“There continues to be a fundamental demand for trading and hedging credit,” adds Ron Papanek, director of strategy at New York-based RiskMetrics Group. “It doesn’t make sense to kill the CDS market just because it’s been exploited.”

Four derivatives exchanges have stepped up to play a clearing role. But will standardization and/or exchange trading sap the vitality of the market for individually negotiated swaps?

James Cawley, founder and CEO of electronic credit derivatives brokerage IDX Capital in New York, says he welcomes “any initiative that mitigates counterparty risk, is offered at a fair price and is open to all users.” He believes a more stable CDS marketplace will ensure further creativity and product innovation.

Katherine Heires ( mediakat@earthlink.net) is a New York-based business journalist with an interest in risk issues and technologies pertinent to trading markets.