Separate Standard, Custom Swaps Based On Liquidity, Says Pickel
June 15, 2009
A liquidity test should define whether a credit default swap will be considered standardized or customized, a split which will determine how the contracts will be treated under upcoming derivatives regulations, Robert Pickel, CEO of the International Swaps and Derivatives Association, told a House Financial Services subcommittee last week.
"I think the question of where a product is in the standardization process is largely a function of how actively traded and how liquid the underlying market is," Pickel said. "Liquidity I think largely drives where the dividing line would be. But that's not an easy determination to make."
Pickel was describing the potential test during an extended exchange June 9 with Rep. Judy Biggert of the Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises regarding effective regulation of the over-the-counter (OTC) derivatives sector.
The standard and custom definitions are important because they will determine how much of the market will end up getting centrally cleared and traded electronically. Only custom products would be kept privately traded, with details delivered afterward to a trade repository for regulator monitoring.
Neither Treasury nor the industry has defined exactly what custom and standard should mean. In the meantime, exchanges, inter-dealer brokers and big banks are all jockeying to bolster or boost market share as rules shift. Sell-side dealers are trying to preserve their prime broker and institutional businesses under the new rules, exchanges are vying for a share of CDS trading and inter-dealer brokers are trying to keep the market OTC.
Discussions on CDS specifications are ongoing with the Obama administration, Pickel said. The talks stem from the Treasury Department's May 13 proposal to require central clearing and electronic trading for all standard contracts and mandated reporting of trade details for all custom contracts.
Upcoming requirements could vary based on three types of CDS. For example, Biggert asked if legislators should specify "three buckets" of OTC products in writing new rules for the market, where some would be required to be electronically traded, another portion cleared and a third--custom trades--sent to a database for regulators to audit.
"I think that is a very good division of how this market will evolve and is already in the process of evolving," Pickel said. "You would have an exchange-traded or perhaps an electronically-traded element that would allow the highly standardized trades to be traded that way, you would have this category of cleared trades and you would have the customized products.
"Keep in mind, a clearinghouse will need to at least daily and sometimes twice daily mark those positions to market and call for margin, so it needs to have a liquid market for that product," Pickel added. "An exchange needs an even higher degree of liquidity: Market-makers who are active in the exchange ready to do a transaction at any time during the trading day."
Conventions could also determine requirements. ISDA has developed a set of standard trading protocols for swaps linked to corporate debt, although the trade group has yet to standardize contracts linked to loans, mortgages or asset-backed securities (ABS).
Which derivatives get cleared or which do not could also be determined by the type and size of the counterparty to the trades, as well as their ability to post collateral or margin. Banks are positing that corporate issuers will face higher hedging costs if they must work through an exchange or clearinghouse. Treasury has proposed that capital and margin requirements be placed on firms that play significant roles in the OTC markets. Clearinghouses and exchanges require such collateral.
