Thursday, April 23, 2009

The Hidden Risks of a Central Counterparty in CDSland

If you didn't catch it yesterday,'s Alphaville had a great piece about why a central CDS (credit default swap) counterparty (read: exchange or clearinghouse) might not work as well as everyone thinks it would. While I still think it necessary, it's obvious that the idea needs work. Specifically, it needs to be integrated with existing clearinghouses/central counterparties to make sure that cross-exposures are appropriately netted.

The piece also raises the point that CDS account for only 11% of the OTC (over the counter, or dealer-to-dealer) derivatives market.

Again, putting CDS trading on an exchange or other central counterparty is important, but at most only 40% of trades might move to such a central counterparty. CDS are not standardized, and standardization removes profit which is why B/Ds are loathe to do it. It needs to be done though, to bring as much of the shadow banking system into the light (along with many other moves, however, like re-splitting commercial and investment banks a la Glass-Steagall, as I previously mentioned). The more trades in a central location, the better. There will always be OTC trading, but it should be for the most esoteric and specialized -- and hopefully rare -- trades.

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