Of all the newfangled financial creations that have caused problems this past year, arguably the most nerve-wracking are derivatives traded over-the-counter (OTC), or in private deals away from exchanges. The concerns are twofold: that the huge growth of these instruments has put the supporting infrastructure under strain, and that the failure of a big trader, or “counterparty”, to honour its commitments could cause chaos. Bear Stearns’s entanglement in credit-default swaps (CDSs) was the prime reason why regulators dared not countenance the Wall Street firm’s bankruptcy in March. With corporate defaults on the rise, the prospect of widespread counterparty woes “overhangs the market like a Damocles sword that is bound to fall”, George Soros, an outspoken investor, has opined.
Efforts to prevent catastrophe date back to 2005, when the Federal Reserve Bank of New York first banged dealers’ heads together over sloppy trade processing. The Bear Stearns debacle, and the expansion of the CDs market to more than $62 trillion in notional value, gave extra importance to making the system more resilient. Adding to the sense of urgency are the strains felt by bond insurers who had written CDS contracts for banks hoping to hedge their mortgage risks.
The biggest push yet to strengthen the market came on July 31st, when, at the Fed’s urging, major dealers set out ambitious goals to cut trading and settlement risks, mostly over the next six months. There was further acknowledgment of the need for change a few days later, with publication of a report by a group of senior bankers led by Gerald Corrigan, former head of the New York Fed.
Much progress has already been made. The backlog in trade confirmations, which spiked alarmingly last summer, has since been cut sharply; roughly half of all deals are now confirmed on the day they are made. The share of CDS trades conducted electronically, around 50% in 2005, is now above 90%. The dealers’ group has pledged to extend the work done in tidying up credit and equity derivatives to commodity, foreign-exchange and interest-rate contracts. Only half of all OTC interest-rate trades are automated.
Other areas of focus include trade settlement and “novation” (when one party replaces another as buyer or seller of protection). The dealers have promised to “hard-wire” cash settlement, rather than physical delivery of bonds, into standard documentation. Physical delivery could distort prices as defaults rise, because the value of CDS positions far exceeds the face value of the corporate debt they refer to. Novation is no less thorny. Buyers and sellers need to know promptly when the party on the other side of the trade changes, but they are being swamped, some with thousands of novation requests a day. There is new technology to solve this, from firms such as T-Zero. But progress is patchy.
Most eyes, however, are on the promise by 17 large dealers to launch a clearing-house for credit derivatives by the end of this year. As with an exchange-based clearer, this would act as a central counterparty, backed by a default fund, and thus greatly reduce the risk of any one player’s failure destabilising the system. And, by “netting” the trades it handles, the clearer could dramatically reduce the overall value of outstanding contracts.
This is primarily a response to regulatory pressure. But dealers have also become worried about the counterparty risks posed by their peers. By turning their market into a hybrid—centrally cleared but still privately negotiated—they hope to make it more robust while safeguarding the fat spreads they earn by hawking OTC products. Exchanges, such as Chicago’s CME, are vying for a share of the market.
Many contracts will inevitably gravitate towards exchanges: index-based CDSs are becoming increasingly standardised. But demand for customised contracts is likely to remain heavy because many like the anonymity, points out Darrell Duffie of Stanford University. All the more reason to find ways, quickly, to blunt that sword.