November 25, 2008 / 3:44 PM / 11 years ago

CDS exchange trading not the only solution

NEW YORK (Reuters) - Exchange trading is being pitched by many as the solution to bringing transparency, governance, and a limit to potential abuse in the $47 trillion credit derivatives market.

The option is no panacea, however. It may offer a few benefits that alternative options in the over-the-counter markets can’t provide, though the standardization of contracts that the exchanges would require would also make it harder for investors to hedge out specific risks.

Tom Harkin, Chairman of the Senate Agriculture Committee, last Thursday unveiled a bill to require swaps and derivatives, including credit default swaps, to be traded only on federally regulated exchanges.

The bill also calls for over-the-counter dealing in the instruments to be banned.

“An exchange is not a sufficient condition, or a necessary condition, to prevent companies blowing up or companies posing systemic risk,” said Craig Pirrong, professor of finance at The University of Houston, in Texas. “It seems to be more of a nostrum than a cure.”

“A lot of companies have lost a lot of money trading on exchanges and its really hard to see how moving this stuff on exchanges is really going to make any difference at all,” Pirrong added.

Exchanges including the Chicago Mercantile Exchange, or CME Group Inc (CME.O), and the IntercontinentalExchange (ICE.N) are scrambling to form clearinghouses for credit derivative trades, the creation of which are viewed as vital to removing the counterparty risk that has plagued the market.

In addition to central clearing, exchanges are working to offer trading of the instruments, a move that would bring additional clarity to prices and trading volumes.

Efforts to launch trading of credit futures on exchanges have failed before, however, in part because users prefer the transfer of cash flows in a swap format.

In a credit default swap a buyer of protection pays the seller an agreed sum each quarter, and is paid the amount of debt insured by the seller in the event of a default.

Critics of mandatory exchange trading argue that the issue is being confused with that of counterparty risk and the market’s lack of regulation, which can be addressed in other ways.

“The credit derivative that the user base is clearly calling out for is still the credit default swap, albeit in a transparent, regulated and more stable environment afforded by a clearinghouse,” said Jamie Cawley, Chief Executive at interdealer broker IXP Capital.

“A more likely solution as this market evolves is multiple clearing houses with multiple trading portals competing with each other for critical mass and liquidity, offering a fair and level playing field combined with lower transaction costs and greater transparency and better regulation,” he added.

EXCHANGE RISKS

Mandatory trading of credit default swaps on exchanges may also leave some users with more risks, as standardization of the products will give investors less flexibility to match a hedge to their needs.

Credit derivative broker ICAP warned earlier this month that forcing the contracts onto exchanges could backfire as it could leave investors or other participants with large basis risk.

So-called basis risk occurs when investors use a security that are not a direct match on an asset to hedge the position, which in some circumstances can lead to greater losses due to the difference in the behavior or value of the two securities.

Meanwhile exchange traded securities will not end trading mishaps that have included the collapse of British bank Barings and U.S. hedge fund Amaranth Advisors.

These, and large losses at French bank Societe Generale (SOGN.PA) and Japanese trading house Sumitomo Corp (8053.T), all occurred with exchange traded securities.

“Even if you had clearing houses, and reduce the counterparty risk of over-the-counter credit derivatives, you could still have financial institutions making very serious mistakes or you could have rogue trading going on,” said Henry Hu, professor of law in banking and finance at the University of Texas.

Calls for a move to exchanges may be the default response in times of crisis, regardless of whether it is the most beneficial solution.

“In some respects it seems to be hashing around for some kind of fix and so lets go to the well and go with something tried and true,” added University of Houston’s Pirrong. “Typically the market is pretty good at deciding what should trade where, and if there are advantages to trading things on exchanges it has a tendency to migrate there and if it doesn’t it doesn’t,” he said.

Reporting by Karen Brettell;

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