Research Primer: Credit Default Swaps Regulation
CreditSights has put together a useful Q&A on the issues surrounding the alternatives for regulating credit default swaps and other over-the-counter financial instruments in the wake of the credit crisis they helped fuel.
CreditSights believes that multiple solutions will be enacted, including either a central counterparty clearing (CCP) style solution or an exchange solution. In addition, a centralized reporting system, in either an exchange or clearing mechanism form should be able to inform the market of the net and gross CDS outstanding on a given name - whether or not it includes buy side counterparties as well as the dealer community.
There are numerous complaints surrounding the CDS/OTC markets, CreditSights says. They fall into one of three broad categories, all of which are interrelated and could be addressed with some form of regulation or market based solution. The categories are transparency, counterparty risk, and market risk.
“We believe that multiple solutions will be enacted. There are currently four proposals being circulated and floated to the NY Fed, all of which will help in some form. Central counterparty clearing (CCP) style solutions are being offered up by three groups (see chart) while one group is floating an exchange solution. We do not believe that OTC CDS (or other derivatives transactions) are likely to go away completely, but very much like the exchange model for certain trades. Allowing all parties access to the central counterparty (the exchange) and having set procedures for clearing, margin posting, and an arbiter for credit events would lead the market to greater clarity and more efficiency.”
We would hope that the market gets both types of facilities set up - a central clearing facility and an exchange for certain products. Either way, we believe that increased market clarity is on its way - either via centralized clearinghouses, or increased regulatory reporting requirements.
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