Swaps Operations Are Holding Up Amid Historic Financial Crisis
September 22, 2008
The people and systems supporting the credit default swaps (CDS) market are thus far weathering the young sector's biggest operational test, say market players. The situation, however, is continuing to evolve following the collapse of Lehman Brothers and the federal bailout of American International Group (AIG)--events that occurred within days of the government's takeover of Fannie Mae and Freddie Mac.
The CDS market lacks key standards and infrastructures that would allow for better management of counterparty risk, such as a central clearing mechanism that could help prevent systemic failures. Yet many who spoke to Securities Industry News last week said that processes involving unwinds, netting, novation and settlement were functioning admirably, despite unprecedented volatility triggered by the bankruptcy of a 158-year-old investment bank and the rescue of the world's largest insurer.
There have been spikes in trading of CDS linked to those firms and the two mortgage giants, as well as sizable increases in unwinds and novations, or trade assignments. Novation volumes peaked as owners attempted to reassign derivatives contracts held with Lehman, which had been a major player in the market until Sept. 15, when it ceased to exist as a counterparty.
Clearing Corp. (CCorp), backed by a consortium of dealers, Eurex, Markit Group and Creditex Group, had expected to begin offering central counterparty clearing for major CDS indexes this month-but its launch has been delayed until early 2009. Discussions about regulating its clearing mechanism, which is undergoing testing, led the New York Federal Reserve to ask that CCorp obtain a New York state banking license, according to a source close to the situation.
So Far, So Good
Sunil Hirani, CEO of Creditex, an interdealer broker and provider of credit derivative processing services, said his firm's systems were functioning "smoothly," despite the high volumes and tumultuous environment. Creditex, acquired by IntercontinentalExchange earlier this month, was one of the processing companies asked by the dealers, regulators and International Swaps & Derivatives Association (ISDA) to participate in an extraordinary risk-reducing trading session last Sunday--as last-ditch merger talks with Lehman faded--to help dealers unwind, reassign and net CDS trades involving the investment bank.
"We were asked to jump-start markets in CDS via representatives of the dealer community, ISDA and the Federal Reserve Bank of New York," Hirani said. "We were fortunate that our employees were able to respond in a very tight timeframe and were able to meet the needs of the market." A Creditex spokesperson said the firm had its broking teams in the office and electronic platforms up and running "on less than an hour's notice" to help support the session.
Helping firms unwind outstanding derivatives trades in which Lehman was a counterparty requires "a lot of effort," said Chip Carver, co-head of Markit Trade Processing, a risk-reducing service for over-the-counter derivative processing. That process is going "fairly well for interest rate derivatives," said Carver, because LCH.Clearnet's SwapClear acts as a central counterparty. "Lehman was a participant in that," he noted.
While credit derivatives don't yet have centralized clearing, "clearly the market's moving toward it," said Carver. "One of the things you can take away from this experience is that the central counterparty model can work in the OTC market-and is working-because it's going along fairly swimmingly at SwapClear."
