OTC CDS Market Not Going Away
June 1, 2009
Fitch Solutions said last week that it expects clearing of electronic credit default swaps (CDS) will be rolled out to "well-capitalized" buy-side firms in the "near future," but that firms will continue to transact outside the recently launched CDS clearinghouses until and unless they're forced to do the opposite.
The predictions from Fitch Ratings' risk services sister company adds to gathering sentiment that over-the-counter (OTC) CDS trading will be preserved, partly via custom contracts, despite notions from some market players that regulation aimed at boosting transparency will push all CDS trades into central clearing or onto exchanges.
Language contained in the U.S. Treasury Department's May 13 proposal to regulate CDS assures the OTC CDS market a future, as it would preserve the business by splitting the CDS market into two sectors: One would comprise "standardized" contracts of the most liquid CDS indexes and single names, all of which would be required to be centrally cleared and traded on exchanges or electronic platforms. The other would be an OTC market containing "customized" and non-standard (or non-corporate) contracts, which would remain traded OTC and cleared bi-laterally, although dealers would be required to report the bespoke trades to a regulatory trade repository for auditing.
This safeguards the OTC CDS market through compromise: Dealers can keep non-standard contracts privately negotiated and shielded from market transparency if they give regulators data on the custom trades.
While Treasury's proposal would have Congress amend laws to move standardized CDS trades onto regulated exchanges and "regulated transparent electronic trade execution systems," it did not ask the same for customized, non-standard contracts. The International Swaps and Derivatives Association (ISDA) has developed a set of standardized data and protocols for CDS contracts. It remains unclear, however, which market--standardized, or non-standard CDS--is or will be larger, as volume estimates vary, and accurate data is hard to come by.
Regardless, or perhaps for that very reason, OTC inter-dealer brokers are fighting Treasury's request to regulators to require exchange-style trading of standard contracts. This, even though some of them view it as a straw man, or bargaining chip, proffered only to force agreement on mandated clearing and reporting of the trades. How much of the market stays OTC, however, and which portion goes to the exchanges, remains to be seen.
The regulatory moves are "unlikely to be the end of the OTC market for CDS," said Damiano Brigo, managing director and global head of the quantitative innovation team at Fitch Solutions. "But how much of it will be there is a more difficult question. Interest rate swaps, [after being] standardized by ISDA, kept on being traded massively OTC; few went through the exchanges. The situation may be different with CDS." Only time will tell, he added.
Some believe the new standardized CDS will lead to "large-scale trading, because... these contracts are fungible," said Farhoud Moaddel, senior director in Fitch Ratings.
Keeping the door open
Yet Treasury has kept the door wide open for CDS novelty, and so has the ISDA: The industry's standardization plans do not include CDS linked to loans or mortgages or asset-backed securities (ABS). And innovation, as the dealers say, is The Street's prerogative. Therefore, it may not take long for custom contracts to find volume. The corporate CDS market, afterall, went from nothing to massive in less than five years after its 1997 launch, cresting $1 trillion in face value in 2002. The market continued rapidly growing until peaking at $62.1 trillion in 2007. It stands now at about $30 trillion.
