Global Credit Default Swap Clearing: Getting the Model Right

Clearing is the year’s hot topic. Why? The world again is in flux. Electronic trading has changed the industry’s economics by enabling brokers to dramatically reduce commissions and apply pressure on clearinghouses to be more efficient. The increase in trading efficiency has become global, as pan-European Multilateral Trading Facilities (MTFs) are gaining strength and applying pressure to the existing European clearing facilities. The recent credit crisis, which forced a number of global financial institutions into bankruptcy or bailout, has driven the need for efficiency even further. In the US, President Obama just announced significant change to business regulation that gives new powers to the Federal Reserve as well as defining more restrictive rules to clamp down on the currently unregulated segments of the financial markets. At the center of the storm is the Credit Default Swaps (CDS) market.

Prior to the recent financial crisis, the CDS market was a lightly regulated $62 trillion, non-transparent market, traded over-the-counter via bilaterally negotiated agreements. Today, this single product has been blamed for adding significant systemic risk to the global financial market.

The meltdown of the credit default swap (CDS) market has put pressure on both regulators and financial institutions to enact a central clearing model. With the crisis as a backdrop, there has been an intense push by both regulators and financial institutions to enhance the development of OTC central clearing models. The clearing world hasn’t been in this much flux since the US paperwork crisis of the 1970s, when the NYSE closed on Wednesdays just to get caught up. This has also placed a significant strain on sovereign Treasuries, Central Banks, and regulators. From chief risk officers to regulators to Capitol Hill, we have all focused attention on ways to reduce financial markets risk. And it seems as if all paths lead back to the Credit Default Swap (CDS) market.

This TABB Group Vision Note focuses on the most difficult clearing challenges: those required to clear OTC CDS contracts. We will look at the mechanics of derivatives central clearing, as well as the challenges of ownership, regulation, valuation, risk management, and the various CDS central clearing models proposed by the major central counterparties (CCP).