Clearinghouses and credit default swaps

Sebastian Mallaby sends me a link to this paper, with this summary statement:

This paper analyzes the market for credit default swaps and makes specific recommendations about appropriate roles for clearinghouses and about how they should be organized. Clearinghouses are not a panacea and the benefits they offer will be reduced if there are too many of them. Further, clearinghouses that manage only credit default swaps but not other kinds of derivative contract may actually increase counterparty and systemic risk, contrary to the assumption of many policy makers.

Comments

I designed the first clearinghouse "clearable" CDS contract for U.S. Futures Exchange, the former EurexUS. We were going to launch U.S. agency CDS futures, and I was responsible for the making the design possible in conjunction with The Clearing Corporation. We used the a new clearing mechanism that I designed to accomplish the clearing.

Despite the fears represented in this paper, any clearinghouse structure makes determining who holds what position at least 10 times easier than the current market structure. This alone would make it worth it, but when you add in reasonable margining and multiple levels of risk backstop prior to the U.S. govt needing to provide funds, it is a no-brainer.

Note that if CDS had been cleared, it would have been Goldmans risk, not the U.S. taxpayers, to examine their counterparty and let them into the club. They would have stopped AIG from accumulating positions long, long ago.

A Chicago Mercantile Exchange spokesman estimated that with a clearinghouse compression of spreads with derivatives would be about 10X. Counterparty risk would be a non-event.

I've read that investment banks don't like the idea at all because they make a lot of money in the OTC, unregulated, derivatives market. If there were a clearinghouse their "special" knowledge of unique derivatives would disappear.

@mickslam

three things:
- if clearing saves so much money, why haven't clearinghouses emerged by itself, e.g. owned by member-banks?
- reg. 'reasonable margning': why would a clearinghouse be better at margining than bilateral counterparties, esp. when clearinghouses don't price balance sheet risk? (see papers C. Pirrong)
- reg. Goldmans risk: it was Goldman's risk all along, and AIG's counterparties were the beneficiaries of its bailout, of course.
Also, H. Shadab says:

"Had AIGFP never entered into the CDS on CDOs, AIG would not have failed in September 2008. However, federal assistance would have been just as necessary. Instead, it would have directly targeted AIGFP‘s bank counterparties—the primary recipients of federal assistance to AIG. Banks likely would have taken on most of their CDO-related risks whether or not AIGFP (or another firm) had sold them CDS protection."

Great paper by the way, see http://ssrn.com/abstract=1368026 also mentioned by Tyler here a couple of months ago.

We have over 100 years in the U.S. without a clearinghouse default, but in 15 years CDS managed to cause something like a great depression. How is the burden of proof on the clearinghouse side with numbers like this?

Also, ziel has it exactly right. Rampant fraud is a good answer for number one.

And clearinghouses price balance sheet risk all day long. Do you think anyone can join a clearinghouse and trade as big as they want? Do you think the federal govt would have allowed AIG to take on a few hundred billion of risk? The point of a clearinghouse is to have clear risk sharing programs. IF there had been a clearinghouse, it would have been obvious to all the participants what they were doing collectively, AND GOLDMAN/DB WOULD HAVE BEEN ON THE HOOK FOR AIG DEFAULTS.

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