Wednesday, December 28, 2011

Implementation issues continue to plague CDS clearing

The madness surrounding forced clearing of Credit Default Swap (CDS) continues to haunt market participants. The Dodd-Frank concept of "if it can be cleared, it must be cleared" is far easier said than done. Imposing a regulatory framework without understanding the implementation path can create all sorts of unintended consequences. And there is no shortage of implementation issues:

1. The details of the regulatory framework for CDS clearing continues to lack full detail. As the dual regulator (SEC and CFTC) discover things they didn't know about CDS, the framework and implementation become more complex.

2. The "cancel/correct" methodology will no longer apply. If one trades a bond for example and makes a mistake in booking the terms, the trade can be cancelled and corrected in a single transaction. With CDS a mistake would mean that a whole new offsetting trade would need to be booked and a new corrected trade would need to be booked separately, turning a single incorrect transaction into three.

3. The dealer involvement as a clearing agent involves significant capital usage because dealers would be required in effect to guarantee client solvency to the clearing house. That means if a fund transacts a CDS that is cleared on ICE, the fund's clearing agent bank would be on the hook if the fund were to fail. Therefore the clearing agent has to commit capital for transactions they are not a party to. This makes the CDS clearing agent business potentially  unprofitable. It is therefore unclear how committed the dealers are to this business in the long term. Which in turn means that clients will need to set up multiple clearing bank relationships to protect themselves from suddenly losing their clearing bank and being unable to execute.  Setting up these relationships tends to be expensive and time consuming.

4. But having multiple clearing banks is not a great outcome either because if a client clears a CDS buy with one dealer and the same CDS sell with another dealer, the two can not be offset even if the positions are held on the same clearing house (ICE or CME).

5. The two clearing houses ICE and CME contracts are not fungible. If a client clears a buy CDS on ICE and a sell CDS on CME, the two can not be offset and the clearing house must be specified at the time of the transaction. Also because of different capital requirements by the clearing houses (#3 above), CDS pricing for clearing on ICE or CME may actually be different. Thus a client would need to maneuver among multiple clearing banks and two clearing houses without the ability to easily move/offset among the platforms.

6. Basis trades are still a problem.  If a fund is short a bond and a CDS in the same credit, the majority of risk is offset.  However the fund will have to post margin on the short bond to their prime broker and margin on the CDS to the clearing house with no opportunity for any offset.

7. The margin requirements on ICE and the CME are completely different. The biggest difference in margin methodology has to do with the so called "jump to default" (JTD). The clearing houses are trying to put protections in place to address not just movements in spread, but also a sudden default. It is effectively a "concentration" charge that drops off as the portfolio becomes diversified as shown in the CME chart below.

If a fund sells protection on a single name CDS (as opposed to an index), and that single trade is all they have on CME, the margin they would need to post becomes enormous relative to what is charged by ICE who has a much more realistic margin charge.  Posting a margin of 80% on a CDS is at least three times what one would post on a corporate bond, even though the risk associated with a corporate CDS and a corporate bond is very similar. Therefore unless one has a diversified portfolio of CDS, clearing via the CME for one or two positions would become prohibitive.  This tremendous difference in margin requirements is yet another issue plaguing CDS clearing implementation in the US.

The documents below describe in some detail the risk/margin methodologies of the two clearing houses ICE and CME.

ICE Risk Presentation

CME CDS Risk Management - Margin
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