Stanford Report, May 6, 2009

Clearinghouses for credit default swaps will not reduce risk, researchers find

BY BILL SNYDER

A plan by global financial regulators to fix the mess created by the misuse of credit default swaps is flawed, says Darrell Duffie, the Dean Witter Distinguished Professor in Finance.

In a working paper, Duffie and Haoxiang Zhu, a doctoral student at the Business School, conclude that the central clearinghouses established to rationalize the $27-trillion market for credit default swaps will not remove nearly as much risk as regulators might hope. What's more, despite a mistaken belief by some commentators, the clearinghouses are unlikely to bring much-needed transparency to trades of credit default swaps, or CDS, Duffie says.

Credit default swaps are essentially insurance policies used to hedge risky bonds. Their misuse has been blamed for the near-collapse of American International Group (AIG) and the subsequent damage to the global financial system in an over-the-counter market, out of view and off the public record.

A clearinghouse stands between buyers and sellers, ensuring that accounts are settled properly when trades are made and that margin requirements have been met. In effect, the clearinghouse acts as a buyer to every seller and a seller to every buyer, reducing the risk of default by either counterparty, as participants in such trades are called.

Responding to pressure from regulators, dealers in Europe and the United States agreed to the establishment of CDS clearinghouses, and by early spring two had been opened, and more are planned.

Duffie, a member of the Financial Advisory Roundtable of the New York Federal Reserve Bank, supported the establishment of a clearinghouse in testimony last year to the U.S. Senate Committee on Banking, Housing, and Urban Affairs. He still supports that idea but maintains that the current implementation is flawed in several respects.

Although the worldwide market for credit default swaps is huge at $27 trillion, it has shrunk by more than 50 percent in the past year, and is too small, as is the number of participating institutions, for a clearinghouse that deals only in CDS to efficiently reduce counterparty risk, Duffie says. Instead, Duffie and Zhu suggest that the clearinghouse should clear a much larger fraction of trades made in the $500 trillion market for over-the-counter (off-exchange) derivatives.

"Our results make it clear that regulators and dealers should carefully consider the tradeoffs involved in carving out a particular class of derivatives, such as credit default swaps, for clearing," the research paper states. Here's why:

Banks reduce risk by trading across various classes of options, derivatives and other financial instruments. Ultimately, positions between two counterparties tend to have offsetting exposures; some are of positive market value to a given counterparty, and others are of negative market value. These have a "netting effect"; that is, only the net amount of market value is at risk in a default by one of the counterparties.

Duffie and his co-author built a theoretical model to clarify an important tradeoff between two types of netting opportunities, "namely bilateral netting between pairs of dealers across different underlying assets versus multilateral netting among many dealers across a single class of underlying assets, such as credit default swaps." The latter of these is the method by which the new clearinghouses will work.

Their model reveals that clearing only credit default swaps can actually increase the risk to the counterparties because the benefits of bilateral netting across asset classes is reduced in this case.

For instance, if Dealer A is exposed to Dealer B by $100 million on CDS, while at the same time Dealer B is exposed to Dealer A by $150 million on interest-rate swaps, then the introduction of central clearing for only credit default swaps increases the maximum loss between these two dealers, before collateral and after netting, from $50 million to $150 million. Additionally, CDS-only clearing would likely result in demands for additional, expensive collateral to protect the two parties. A CDS-only clearinghouse would work if the market were larger, Duffie and Zhu say.

Making matters somewhat worse was the decision to establish multiple clearinghouses. Having more than one clearinghouse reduces the netting effect even more, says Duffie, adding that each additional clearinghouse exacerbates the problem.

Even though the clearinghouse plan is flawed with respect to reducing counterparty risk, it has been suggested that establishing these new entities would at least add much needed transparency to the CDS market. Actually, the same level of information about CDS trades that would be available to regulators in a clearinghouse is already available through the Depository Trust and Clearing Corporation (DTCC). With or without a clearinghouse, there is no plan to reveal trades to the public. So, the stories of improved transparency are a red herring.

Moreover, a clearinghouse can only clear standard transactions. But most of the credit default swaps initiated by AIG are not standard and would never have been cleared, even if a clearinghouse had existed years ago.

Bill Snyder is a freelance writer.