 Matt Nelson
Director, Market Intelligence
With so much discussion over market reform and a search for the best fix for the state of the economy, one of the most pressing issues pertains to the proposal of a central clearing party to deal with credit-default swaps.
Over the last 6 months the world has changed in terms of how we conceptualize risk. Big banks and brokers are no longer considered "too big to fail." A central counterparty would eliminate bilateral credit risk among its direct participants and mutualize risk which would not only net payments but also collateral obligations resulting from exposure of underlying positions. Central clearing can be an efficient means of managing risk provided its processes and systems are effective. This would include strict membership criteria, sufficient capitalization through default funds and an efficient margining and collateral process driven by accurate valuations of underlying contracts.
It's impossible to manage risk without a clear accounting of your positions and their market value. To better understand systemic risk, regulators are likewise demanding more transparency in the derivative positions held by financial institutions. Centralizing information on positions for both reporting and settlement of cash flow resulting from derivative contracts, like you find in DTCC's Trade Information Warehouse, represents an important evolution in the efficiency of this market.
Certainly, a central clearing party could help the industry get a long-overdue handle on counterparty risk, particularly when it comes to credit-default swaps.
However, central clearing is not a panacea for risk because not all products are likely to be eligible for clearing. Complex instruments and products won’t fit into exchange models. Those instruments aren’t likely to disappear, so the risks associated with them won’t either. Further, since investment managers do not typically participate in the clearing process directly, a CCP can’t truly eliminate all counterparty risk. It will also be impossible to standardize and list all derivative contracts in an exchange-traded model.
Additionally, the industry must ask itself what happens after clearing (through a CCP or a stratified model). There is no finality to the settlement of swaps, as the contracts can last 30 years or beyond. This portion of the contract’s lifecycle is where perhaps the greatest risk comes into play.
There is no doubt that several clearing parties for CDSs would be counterproductive to the efficiency so desperately needed in our credit markets today. But by relying merely on a single centralized clearing party as the silver bullet for managing counterparty risk would be the equivalent of the boy with his finger in the dam.
Central clearing represents an important evolution in the market but financial institutions must also take responsibility to ensure their own credit policies and systems are effective in managing bi-lateral risk. Many firms still lack the basic infrastructure to reconcile their derivative positions and optimize their use of collateral to mitigate risks associated with a counterparty default.
Central clearing represents an important evolution in the market but financial institutions must also take responsibility to ensure their own credit policies and systems are effective in managing bi-lateral risk. Many firms still lack the basic infrastructure to reconcile their derivative positions and optimize their use of collateral to mitigate risks associated with a counterparty default.
I’ve heard it said that derivatives are like a chainsaw. They are an effective tool but you better have the appropriate training and safety equipment or you’re going to get hurt.
In order to truly get a grasp on counterparty risk, the industry should be equally focused on a given firm’s ability to monitor and manage counterparty risk across asset classes and geographies by ongoing management of collateral and reconciliation of portfolios. A CCP is just one weapon (and a relatively blunt one, at that) rather than the end-all, be-all solution needed to ensure that operational risk doesn’t turn into systemic risk.
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