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Central derivative clearing may concentrate risks
May 15, 2009 / 7:08 PM / in 8 years

Central derivative clearing may concentrate risks

By Karen Brettell - Analysis

NEW YORK (Reuters) - Plans to require central clearing of many derivatives may concentrate the risks of large dealer collapses among a few participants, rather than removing it from the market altogether.

The Obama administration moved on Wednesday to exert more control over privately traded derivatives, which are estimated at around $450 trillion globally and have been blamed for sparking the global credit crisis.

The plan includes greater supervision and regulation of the market and also requires that standardized derivative contracts be centrally cleared.

The move to central clearing is viewed as critical to removing the risk of a possible systemic collapse if the failure of a large dealer sparks a chain of losses and defaults worldwide.

By concentrating derivatives exposures among a small group of platforms, however, they may be adding other risks to the market.

“We may be substituting concentration risk for systemic risk and if we’ve got a small pool of players that have to put up the money to back the clearinghouses, we’ll see if that’s a good or bad thing,” said Joel Telpner, partner at law firm Mayer Brown in New York.

“Even if you assume that the concentration risk is not a big deal, because clearinghouses will manage the exposure in a way that assures adequate funds to meet potential defaults, we still have the issue that we’re likely to have multiple clearinghouses and systems and how are they going to reconcile exposures with each other,” he added.

IntercontinentalExchange Inc (ICE.N) and CME Group Inc (CME.O), which runs the Chicago Mercantile Exchange, are viewed as the two main contenders to clear the majority of credit default swaps in the U.S.

ICE, which began clearing trades in March, benefits from the support of 9 dealers, which have a 50-50 equity-sharing partnership with the exchange.

CME’s CDS proposal, which involves both trading and clearing, has the support of hedge fund giant Citadel. It has not yet launched, as CME continues talks with new partners in the venture.

“I don’t think clearinghouses remove the risk, they transfer the risk and in theory in transferring the risk to that structure they do reduce the overall risk,” said Kevin McPartland, senior analyst at research and advisory firm TABB Group in New York.

Cleared CDS volumes are not yet high enough for a dealer default to pose any large problems, though dealers that are members of the clearinghouse may risk being required to cover the costs of a member firm defaulting as volumes grow, he said.

Lehman Brothers failure in September accelerated concerns over the health of large banks, ultimately leading to government measures designed to support financial institutions and bring more controls to derivative markets.

Clearinghouse members post margins and other deposits, which are designed to mitigate losses in the event of a member’s collapse. However, its not certain these would be enough in the worst case scenario.

“Exchanges are typically AAA rated because they have the backing of all the brokers who participate in the exchange and in addition they have capital and margin requirements, which tend to make them quite safe,” said Robert Claassen, partner at law firm Paul Hastings.

In a worse case scenario, however, of multiple bank failures and large swings in the value of CDS contracts, problems could arise.

“I think that one of the key challenges of clearing credit default swaps is that just given the nature of the contracts there can be very rapid margin calls in very large amounts,” Claassen said.

“CDS costs are based on the likelihood that a default occurs and the moment a bankruptcy risk hits the market the value of the contract can jump enormously,” he said.

“In a worse case scenario if dealers fail and the value of the contracts have moved significantly, there could be a situation where there is insufficient margin,” Claassen added.

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