Pricing and liquidity concerns remain

Market consensus finally appears to be forming around CDS central clearing, despite the lack of regulatory clarity. However, concerns remain about margin pricing and the liquidity of the CCPs themselves. (The full SCI Special Report on CDS clearing can be downloaded at the bottom of this page.)

"Central clearing is the cornerstone of the regulatory overhaul in the US, but it has been in flux since last summer when chatter about regulatory change first emerged," an official at one US investment bank explains. "Since then, the issue of end-user carve-outs, the creation of investment bank swaps subsidiaries and the banning of proprietary trading has muddled the picture. However, most clients over the last nine months have got comfortable with the systemic benefits of CDS central clearing."

Michael Hampden-Turner, structured credit strategist at Citi, agrees that although the initial regulatory goal of central clearing for CDS was to mitigate counterparty risk, the process has become more about achieving transparency. "Since AIG, banks have started hedging their counterparty risk - the exception has been supranational bodies, sovereigns, insurance companies and CDPCs. So, the amount of counterparty risk in the system has decreased naturally as participants have become more aware of it," he says.

He adds: "The biggest advantage of clearing is that it increases the confidence of regulators and investors about the risk that's in the system. A good example of this is the sovereign crisis: the DTCC released data to regulators about Greece CDS positions and it seems, judging from their reaction, they were reassured by the figures."

There are an estimated 2000 CDS names, of which 1500 are actively traded and 200-300 are very liquid. But, for each of these credits, there are contracts in multiple currencies and maturities, which all require accurate pricing on a daily basis in order for the right margin to be posted at a clearing house. Hampden-Turner says that it is easy to get prices for the top 700 names and - as most of the risk lies here - if only these contracts are cleared, it's still a positive development for the market.

However, one significant concern about clearing OTC trades via a CCP is that if it's impossible to reliably price a contract at all points in time, it is impossible to call the appropriate variation margin, according to Alexander Yavorsky, vp-senior analyst at Moody's. "This not only cancels out the benefits of having a central counterparty, but also pollutes the platform. It forces other clearing members to take on unnecessary risks," he explains.

A related risk arises if entities, such as corporates or sovereigns, that don't post collateral when they enter into OTC derivatives trades are required to post margin. Posting variation margin requires money to be moved back and forth every day, so a clearing house can ask for more collateral if there is a spike in market volatility.

But this is a liquidity call that is unmatched with any cashflows from these entities' daily business. Yavorsky warns that imposing this 'just-in-time' liquidity requirement could lead a corporate to run out of cash and default, which could in turn imperil the clearing house.

There is also concern over the liquidity of the CCPs themselves. When a clearing member fails, the clearing house has to continue posting collateral to the other members that hold the opposing positions to the failed portfolio when it isn't receiving any cashflows itself.

Consequently, it becomes important to find a buyer for that portfolio as soon as possible. But the cost of finding a buyer for a portfolio can be steep.

CS & JL