CDS Clearing House Will Not Fix Credit Default Swap Mess
A central clearing house will do little to fix the mess created by the misuse of credit default swaps, according to a new paper* by Darrell Duffie, professor of finance at the Stanford Graduate School of Business. In the preliminary research paper, Duffie, and GSB doctoral student Haoxiang Zhu, conclude that the central clearing houses founded to rationalize the $27 trillion market for credit default swaps will not remove nearly as much risk as regulators might hope.
What’s more, despite a mistaken belief by some commentators, the clearing houses are unlikely to bring much needed transparency to trades of credit-default swaps, or CDS.
Duffie, a member of the Financial Advisory Roundtable of the New York Federal Reserve Bank, supported the establishment of a clearinghouse in testimony last year to the U.S. Senate Committee on Banking, Housing, and Urban Affairs. He still supports the idea, but maintains that the current implementation is flawed in several respects.
Although the worldwide market for credit default swaps is huge at $27 trillion, it has shrunk by more than 50 percent in the past year, and is too small—and the number of participating institutions is too small—for a clearinghouse that deals only in CDS to efficiently reduce counterparty risk, says Duffie.
Instead, Duffie and Zhu suggest that the clearinghouse should clear a much larger fraction of trades made in the $500 trillion market for over-the-counter (off-exchange) derivatives.
Our results make it clear that regulators and dealers should carefully consider the tradeoffs involved in carving out a particular class of derivatives, such as credit default swaps, for clearing.
*Does a Central Clearing Counterpart Reduce Counterparty Risk?
You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
