Europe moves toward global credit default swap clearinghouse

Are the markets getting closer to an American or European or possibly a trans-Atlantic clearinghouse for credit default swaps? The momentum is headed in that direction, as dealers and investors in Europe have moved a step closer to meeting regulators' demands for greater transparency and reduced risk.

Dealers in Europe have agreed to new conventions that make it easier to offset and cut the number of outstanding contracts in Europe, Bloomberg News reported Monday. The changes will have the effect of increasing transparency and reducing systemic risk in Europe's market.
Credit default swaps (CDSs) -- a derivative that's really a form of credit default insurance -- are used by banks, hedge funds, insurance companies and other institutional investors to hedge against or to speculate on losses on debt. In its purest form, a swap pays a buyer face value of a debt in the event the borrower fails to pay that debt obligation. Swaps are also used to hedge/speculate on commodities, currencies, and interest rates, among other investment classes.

An end to 'swaps gone wild' era

Credit default swaps have drawn the ire of regulators on both sides of the Atlantic because of speculative excesses and other capital market distortions that built-up in the global financial system during the past decade. A clearinghouse reduces risk via capitalization from buyers and sellers, via acting as a counterparty to every trade, and by enabling regulators to assess systemic risk via monitoring trader positions and prices, among other monitoring tools.

Further, although systematic, longitudinal studies by the U.S. Congress and by the European Union, and other agencies, have not been completed yet, the initial evidence suggests that credit default swaps ruined American International Group (AIG), led to the collapses of Bear Stearns, Lehman Brothers, and also severely wounded Merrill Lynch, which was later sold to the Bank of America (BAC).

As part of reforms sought by E.U. regulators, nine banks and brokers have committed to using one or more clearinghouses within the 27-nation region by July, Bloomberg News reported.

Meanwhile, in the United States, traders started using a central clearinghouse for swaps in March, with IntercontinentalExchange (ICE) reporting that it has guaranteed more than $1 trillion in swap contracts.

Will regulators go too far?

Energy Trader Paul Schmidt told DailyFinance Monday the move toward a clearinghouse on both sides of the Atlantic will reduce systemic risk, but he doesn't want regulators to go too far.

"The Intercontinental Exchange clearinghouse is welcome because it has improved transparency and given regulators a much wider picture of risk in the system," Schmidt said. "But one thing I wouldn't want to see is increased capital requirements. That could hurt price discovery by reducing the number of traders in the market," leaving pricing up to just larger institutional investors.

Schmidt, who has used derivatives in the past, is concerned that "the regulatory zeal will spill over into the energy market," from the bond market "where most of the abuses occurred."

"What we need now is not fewer players in the energy market, but more players," Schmidt said. He argued that fears of speculators 'artificially' boosting oil or gasoline prices "are not rooted in evidence." Any speculative bubble, Schmidt argued, would soon be corrected by panic selling, if fundamentals did not justify the high price.

Economic Analysis: The move by the E..U., mirroring U.S. efforts toward a clearinghouse for credit default swaps, is welcome. Clearinghouses, backed by regulations that impose large fines for violations, will decrease unneeded risk and market distortions. However, given the winnowing of hedge and investments funds stemming from the recession, regulators should tread cautiously regarding capital requirement changes. What we don't want is a system whose capital requirements reduce market participation down to the 'king fish,' as that would hurt price discovery.
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