THE BASIS POINT

Credit Default Swaps Soon To Be Exhange Traded, More Transparent

As the Lehman collapse showed us, the market for credit default swaps can wreak havoc on markets, since investment banks and hedge funds were making these markets in private. CDSs are insurance contracts on bonds and other credits that are a $62 trillion market, making it four times larger than the stock market, and utterly unregulated. CDSs are traded on over-the-counter markets and nobody knows how much CDS exposure anyone else has. If you owned a bond, and you wanted to hedge against default risk, a CDS is a smart and fair tool to do so—that’s why investors use them. But you don’t even have to invest in a particular bond to buy CDS to hedge it. You can just buy CDSs on any old security you want to bet that it will default. In modern finance, even this money-making (rather than hedging) tactic would be considered fair if the market were transparent, you were required to carry adequate reserves for your speculative activity, and investors & counterparties could see your positions.

It looks like we’re getting a bit closer to that transparency as competition is building between the IntercontinentalExchange (ICE) and the Chicago Mercantile Exchange/Citadel to create the market for exchange-traded CDS:

IntercontinentalExchange Inc (ICE.N: Quote, Profile, Research, Stock Buzz) said on Friday it is building its own credit-default swaps platform, setting the stage for a battle for a piece of the exchange-based clearing of CDS with CME Group, which announced its own solution with Chicago-based hedge fund Citadel Investment Group earlier this week.

Given the size of this market, the stakes are huge for whichever firm wins. And markets will benefit by making the speculative derivatives more transparent. The Financial Times also reported on the competition between ICE and CME/Citadel:

The Clearing Corporation – a Chicago-based clearing house backed by big users of credit derivatives, such as Goldman Sachs, Citigroup, JPMorgan, Morgan Stanley and Bank of America – said it would join ICE to create a “global clearing solution” for CDSs. Others involved are Creditex and T Zero, subsidiaries of ICE that handle post-trade processing for CDSs, Markit Group, a provider of credit derivatives pricing systems and Risk Metrics, a risk management specialist. A subsidiary of ICE, ICE Trust, would function as a “global clearing house and central counterparty for CDS transactions”.

The move comes in response to this week’s announcement by the CME Group, the world’s largest futures exchange, and Citadel, the hedge fund, that they would join forces on a similar venture to begin operations within 30 days.

The futures industry is marked by tension between the CME – which controls 98 per cent of listed derivatives in the US – and the big banks and dealers, which are loathe to cede more power to the exchange by allowing it to establish itself as a force in the CDS market.

The banks have a natural partner in ICE, which last year launched a bidding war for the Chicago Board of Trade, which was eventually won by the CME.

Since the CME purchased Nymex, the New York energy exchange, in August, it also competes with ICE in clearing over-the-counter energy contracts. ICE first signaled its intention to move into CDSs in June, when it paid $625m for Creditex.

You can be sure an exchange solution for CDSs will emerge quickly because of the massive profit potential for firms controlling those trades, and this will help with the transparency. The rest will have to come from regulators un-doing the free-for-all of unregulated derivatives created by Phil Gramm’s CFTC modernization earmark in a 2000 spending bill. The first casualty of this derivatives deregulation was Enron, and then paved the way to the CDS market buildup.