Central CDS Clearinghouse

As reported in Bloomberg and elsewhere, a group of 17 banks have come together to create a clearinghouse system to move credit default swap (CDS) trades and cover a failure by one of the market-makers. While the amount of potential CDS loss is closer to $2 trillion, and not the entire $62 trillion in notional value that often gets reported, the possible market exposure is still significant and should be addressed. Just a little over a week ago we discussed the CDS counterparty risk issue in an article that mentioned how regulators and the Fed were looking for ways to limit the exposure from a counterparty failing to meet its obligations.

Of concern is not so much the failure of one bank or counterparty, but the possible systematic risk that would be felt by the entire financial system. The new system will allow the market to trade against the central counterparty, mitigating the consequences of failure by a major institution. In addition to systematic risk, the system should also help prevent a Bear Stearns-type of failure since there will be less need to make a run on a specific institution.

Other benefits of the clearinghouse will be increased liquidity and transparency. Providing a clearinghouse will encourage more swap trading, and larger volume will allow for a more efficient market and more reliable mark-to-market process. This will make it easier for investors to have a better idea of the true exposure that a company is taking, allowing for a better valuation and more efficient stock price. Currently, it is difficult for companies to even know what their credit risk exposure is given that the CDS market is thin and delayed, not to mention opaque at best. The new center counterparty system is a good step towards helping to shine light on the CDS market by reducing credit risk, and allowing for more real-time price discovery.