Media reports in recent months have been filled with accounts of CDSs (credit default/derivative swaps), those complex, opaque instruments sold by AIG that
nearly toppled the global financial system. They are the cornerstone of a $700 trillion worldwide industry that has sliced, diced, and shifted astronomical amounts of risk around the financial services sector at dizzying speed and—according to critics—within a regulatory vacuum. On the subject of disclosure, for instance, Fed chairman Ben Bernanke recently lamented the insufficiency of contract-for-difference regulation, noting that few regulators, investors, AIG employees, or AIG shareholders ever knew that the once-mighty AAA-rated insurance behemoth was actually a giant hedge fund that happened to be strapped onto an insurance company.
Already, political debate surrounding the Derivatives Markets Transparency Accountability Act of 2009 suggests that much of the exponential growth of the last decade will be curtailed—not least because of a possible ban on trading in a CDS unless the investor actually owns the underlying instrument. The key issues now are transparency of information, pricing, and, above all, counterparty risk management. Much of the potential regulation is likely to put the major Wall Street broker–dealers at odds with the ultimate end users of CDSs—buy-side institutional investors.
“By the end of 2009, we will have seen more regulatory and structural changes to the CDS market for the year than we have seen in total over the last decade,” observes Omer Abdullah, managing director at Smart Cube, an independent global investment research firm. “On top of the banking sector continuing to muddle through a major shakeout in terms of leverage, profitability, and risk management, the CDS business is now facing a crucial milestone in its history.”
Among the most important developments are the expansion of the coverage and transparency of the publicly accessible data warehouse of the DTCC (Depository Trust Clearing Corporation), and the launch of two new clearinghouses for CDS trades. In years past, a CDS trade was an entirely private, OTC (over the counter), voice-brokered arrangement between a seller of default protection and a buyer. Up to now, statistics relating to such parameters as size of positions outstanding for any given underlying reference instrument, balance sheet exposure for any one broker deal, or counterparty risk have always been shrouded in darkness.
DRACULA IN DAYLIGHT
An old cliché about disclosure in financial markets holds that full informational transparency is to dealers as daylight is to vampires. Look at the radical restructuring of the equity trading industry in the US, for example. It transformed the clubby New York Stock Exchange into a market dominated by electronic communication networks. Along with decimalization, NASDAQ has undergone a ruthless expansion to become an electronic exchange focused purely on the best price for investors and on the absolute lowest transaction costs. Bid–ask spreads in equity trading for major names have rapidly contracted down to fractions of a basis point. Step by step, the miniaturization process has hit profit margins in the equity trading business.
Despite the equation of greater transparency with lesser profitability, the CDS industry has made substantial progress toward improving disclosure. (Read more about Successful Self-Regulation.) The DTCC recently moved ahead with developments to its CDS trade information warehouse, which, in response to regulatory concerns about transparency, first started publicly disclosing CDS-related trade data in November 2008. And as the next step in what may turn into a fully transparent industry-wide confirmation system, the DTCC is setting up a limited-purpose trust company that will house the functions of the DTCC’s Trade Information Warehouse for credit derivatives.
The new entity, Warehouse Trust Company, LLC, has filed applications for membership in the Federal Reserve System and with the NYSBD (New York State Banking Department). It is expected to take part in a collaborative global regulatory scheme involving US and European regulators, and will establish a subsidiary in Europe to facilitate the offering of regulated data disclosure services for the European market.
The DTCC’s move is part of an effort by potentially competing platforms and exchanges to coordinate their activities closely. Since January 2009, the DTCC has been facilitating central counterparty trade guarantees for CDSs in conjunction with ICE (Intercontinental Exchange) Trust and the Clearing Corporation, CME and Citadel, LCH and the London International Financial Futures and Options Exchange, and EUREX.
TWO NEW PLATFORMS: ICE, CMDX
The DTCC’s developing role as a global depository for CDS trade data may significantly improve the complex issue of confirmation of trades. Still, the real action has been in attempting to eliminate counterparty risk.
In an OTC trade, the buyer of protection assumes the full risk that the seller of protection will not have sufficient solvents to cover any losses, should a credit even occur. Investor concerns about a counterparty’s solvency or ability to post collateral—much less about any possible future credit event occurring in an underlying reference instrument—are more than enough to rattle the entire system, as US taxpayers know all too well.
Along these lines, perhaps the biggest development in the rebuild of infrastructure for the CDS market was ICE’s launch of an industry-wide clearing system in March 2008. ICE Trust™, a limited-purpose bank regulated by the Federal Reserve System, the NYSBD, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, now serves as a central clearing facility for CDSs. Although ICE Trust is an ICE subsidiary, its membership, board of directors, officers, and operating staff are separate from ICE’s other exchange, clearinghouse, and brokerage operations. Membership is open to institutions that meet objective financial and eligibility standards. ICE Trust is also open platform, accessible to all suitable trading platforms.
With one CDS clearing system already running, the second major push into establishing a CDS clearinghouse is the launch of CMDX by the CME Group and the Chicago-based Citadel Investment Group, LLC. CMDX, which is now adding new members and expects to go live before the end of the year, is an open-architecture electronic trading and migration platform for CDSs, available to all qualified market participants. Trades executed, booked, or migrated through CMDX are processed directly to CME Clearing, which is a AAA-rated independent entity and one of the largest clearinghouses in the world. According to the CME Group, CME Clearing provides the safeguards of a central counterparty and the benefits of full-trade life cycle management, including settling accounts, clearing trades, collecting and maintaining margin, regulating delivery, and reporting data. Since its inception over 110 years ago, CME Clearing has never defaulted on any obligation to its clearing members.
Within a few months, then, two new electronic platforms to clear all CDS trades have been created, in arguably the biggest shake-up in the history of the CDS market. Many pressing problems will be addressed immediately, particularly the question of the frozen liquidity that has kept much of the CDS market barely running idle.
IN THE OFFING
In the near term, then, CDS trading should experience a huge boost to liquidity as the thorny issue of counterparty risk, which has nearly paralyzed the market, is more or less resolved. Through recent months, few CDS market participants have been willing to price the implicit counterparty risk that all OTC CDS trades entailed, much less take exposure to it. In other words, no one has wanted to guess where the next AIG scenario would unexpectedly pop up.
In addition, the CDO (collateralized debt obligation) and synthetic CDO market (which, like the CDS market, has been stagnant for nearly a year) could soon see far greater liquidity. Inevitably, the profitability of vanilla CDS trades will fall with greater transparency, but there should also be reductions in the cost of trading—most notably, by eliminating the onerous and expensive process of counterparty credit analysis and maintaining margin collateral. With a centralized clearing system and implicit near-elimination of counterparty risk, a huge number of middle-office and back-office risk functions will be made redundant.
Eventually, there could even be a further move toward a fully price-transparent TRACE (Trade Reporting and Compliance Engine) system of disclosure in which all trades and prices are made public. Of course, immediately after the TRACE system mandated all broker–dealers to report the pricing and size of all TRACE-eligible bonds in 2002, bid–ask margins shrank. Some estimates put the revenue loss to the bond broker–dealer business at some $1 billion during the first year alone.
UP IN THE AIR
But even the resolution of the counterparty risk dilemma raises dilemmas of its own, such as whether addressing counterparty risk will lead to increased participation from insurance companies using the CDS market to create synthetic bond portfolios. Still, that’s far from being the only big-picture issue when it comes to the future of the CDS market.
For example, there are now two highly similar CDS clearing systems—ICE and CMDX. Both, as private, shareholder-owned entities, will be competing for the same business among the same core group of customers. In terms of liquidity, which will gain critical momentum? So far, many broker–dealers have voted for ICE, which was the first to launch, has already gained a fair degree of liquidity, and has no connection with any single hedge fund.
There’s also the question of how long the OTC CDS market can continue to enjoy a regulator-free nirvana. As more of the market migrates toward a highly regulated and transparent clearing system, many are asking whether regulators will simply allow the politically connected broker–dealer industry to pick and choose which trades are customized and therefore not liable to the burdensome disclosure and regulatory requirement of clearing through an exchange.
Another urgent matter of interest is the extent to which a centralized clearing system will affect the limits of proprietary risk taking and capital charges. (For a further discussion of a centralized clearing system, see this article.) For the major broker–dealers, the greatest revenue drivers for banks over the last decade were not no-risk vanilla trades, such as brokering the sale of a block of equities. Instead, running a multitrillion-dollar CDS book, which was rarely perfectly matched at any given time, was the goose that laid the golden egg. Just one major CDS dealer, JPMorgan, earned $5 billion from CDSs in 2008, which was one of the worst years on record for the financial services sector. Presumably, the near-eradication of counterparty risk will lead to lower capital charges, more CDS volume, more liquidity, and thus more overall profitability—unless the government gets in the way.
Finally, there’s transparency. Aggregate contracts and market volume are already transparent through both the DTCC data warehouse and the ICE clearing platform. So just how fast and how far will transparency go? In addition to pricing, tenor, and size, will investors be able to monitor backlog orders on individual reference names and the identity of counterparties on individual trades? In other words, will CDS trading become as transparent—and margin thin—as major US listed equities?
THE LOBBY
The future of the regulatory side of the market is still hazy, with several powerful industry constituents pitted against each other. Even within SIFMA (Securities Industry Financial Markets Association), interests are hardly aligned. Many of SIFMA’s 650 members are buy-side investment managers who certainly cannot be described as fans of an opaque, nonregulated environment for OTC CDSs. Others are broker–dealers, for whom increased standardization and transparency, particularly in the area of price and volume discovery, inevitably lead to a sharp reduction in profitability. Yet, for the investment management industry, lower broker–dealer profitability means lower trading costs for fund managers. There’s no shortage of internal conflict.
Knowing full well that much of the CDS market may be facing massive regulatory assault, major dealers have wasted no time in protecting their interests, establishing the CDS Dealers Consortium in November 2008. The nine biggest participants in the CDS industry—including Citigroup, Bank of America/Merrill Lynch, Goldman Sachs, and JPMorgan—created this lobbying organization shortly after five of its members accepted federal bailout money.
So far, the big money from the sell side is winning hands down. SIFMA, which ostensibly represents the entire securities and investment industry, is clearly adopting the broker–dealers’ point of view. At a February 2009 hearing on derivatives before the House Agriculture Committee, Edward J. Rosen, a partner at the Wall Street firm Cleary, Gottlieb, Steen & Hamilton, testified on behalf of SIFMA. Rosen is one of the leading derivatives lawyers in the industry and a paid lobbyist for the CDS Dealers Consortium. Public lobbying records published by the New York Times indicate that the Consortium has so far paid Rosen $430,000 for four months of lobbying work.
Wall Street firms as a whole, through political action committees and their own employees, gave $152 million in political contributions from 2007 to 2008. Wall Street ranks alongside the health care and pharmaceuticals industries as one of the best-financed lobby groups involved in policy debates.
Regardless of the outcome in Washington, the CDS landscape is changing fast. There’s an uncontested need for some type of normally functioning CDS market, but it’s still anyone’s guess exactly how CDS trading will look by the end of this year. It’s now beyond question, however, that CDSs will continue to exist in one form or another. “The CDS market has been maligned for all the wrong reasons,” says Arjun Kondamani, a trader at Northeastern Securities who has been active in the CDS market for nearly a decade. “If it is well regulated and the counterparty risk issue is adequately addressed, then it is a great market for investors.”
PLUS OR MINUS INFINITY
The lobby’s impressive expenditures may be spendthrift, anyway, since the contraction of the wide profit margins on vanilla OTC trades in the CDS market could be a sign that the sun is setting on another of Wall Street’s salad days. “For what are now vanilla OTC CDS trades, the market is clearly moving very quickly toward standardization, increasing transparency of pricing, and massive mitigation—if not a near outright elimination—of counterparty risk,” observes Smart Cube’s Abdullah. “With a mature industry, homogeneity of product, and increasing informational efficiency, the laws of markets dictate that profit margins in the CDS world—just as in the listed equity world—will be squeezed thin. That said, less revenue for one part of the industry—CDS dealers on the sell side—implies lower costs for the other part—institutional investors on the buy side.”
In the end, innovation and rapidly changing markets should lead to yet another fad for the Gaussian copula function, that obscure mathematical formula used to value and price synthetic CDOs, a huge market which exploded into existence on the back of the OTC CDS industry. “The markets for these financial products are highly cyclical,” says Kondamani. “Through innovation and ingenuity, there will always be a hot, up-and-coming new product with new profit margins.”
–Theodore J. Kim, Esq., CFA, FRM, is a New York-based managing director of Smart Cube, an independent global research firm focused on capital markets and investment management.
This article was originally published in the Summer 2009 issue of the Investment Professional.
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