The scheme is to collectively absorb the risk rather than permit a domino collapse. In other words, Clearing Co. will act as a mutual insurer of the swaps, with individual members ponying up the moolah as necessary upon CDS default events taking place.
Four things evident from the scheme: First, the Fed would be powerless if systemic risk becomes reality. Second, note that hedge funds are involved in the discussions. Third, a recognition that CDS risk is serious and will be upon us sooner rather than later. Fourth, and perhaps the most important, is the multi-lateral termination of CDS. This makes sense inasmuch as multi-level CDS on the same instrument make no sense at all.
Might work to attenuate systemic risk. But if a substantial number of CDS go through events of default, the consortium itself will be seriously stressed because the capital accounts of the individual members are not in good shape. A few CDS calls for payment by Clearing Co. on these bums could actually create systemic risk for that reason.
It will be interesting to see if Clearing Co. will be able to rationalize instruments which are as individualized as CDS.
Reminds me a bit of the super-SIV scheme which was a joke.
Watching these scamsters negotiate percentages of liability and contributions to Clearing Co. will be very intereting. They will all minimize their CDS holding statements in order to minimize their contributions. If enough get away with it, C Co. may be seriously underfunded. Not that it could handle a systemic failure in the first place.
The B'berg article.
bloomberg.com
Regulators and banks agreed to changes aimed at easing the risk of a collapse in the $62 trillion market for credit-default swaps.
Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. are among the 17 banks creating a system to move trades through a clearinghouse that would absorb a failure by one of the market-makers, the Federal Reserve Bank of New York said yesterday in a statement following a meeting with the firms.
This will reduce ``the systemic risk when a large counterparty fails,'' Tim Brunne, a Munich-based credit strategist at UniCredit SpA, said in an interview today. ``A large portion of the market would be trading against the central counterparty, and that would be a good thing.''
A central counterparty, more automated trading and settlement and other fixes ``will help improve the system's ability to manage the consequence of failure by a major institution, and we expect to make meaningful progress over the next six months,'' New York Fed President Timothy Geithner said in a speech to the Economic Club of New York yesterday.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value should the company fail to adhere to its debt agreements.
Investor concern that the market may fail was fueled in March when Bear Stearns Cos., then the fifth-biggest U.S. securities firm, faced a cash squeeze. The central bank agreed to back an emergency sale of Bear to JPMorgan Chase & Co. in part because of the systemic losses that would have resulted if the firm had filed for bankruptcy, Geithner said.
Liquidity `Key'
The Fed has conferred with banks since September 2005 to improve processing and settlement in the market. Ten of the 17 banks at the meeting yesterday were owners of Chicago-based Clearing Corp., which has said it will start guaranteeing credit-default swap trades by September.
A guarantee may encourage more trading of credit-default swaps, said NanaOtsuki of UBS AG, one of the banks involved in the agreement.
``Increasing liquidity as a result of the settlement house would be the key,'' said Otsuki, head of debt and equity research for Japanese financial institutions at UBS in Tokyo. ``Larger trading volume means higher efficiency.''
Investment firms AllianceBernstein LP, Citadel Investment Group LLC and BlueMountain Capital Management LLC joined the meetings yesterday for the first time.
Trade Settlement
In addition to a central clearing mechanism, the group agreed to include in standard trading documents a mechanism for settling trades with cash instead of having to physically deliver the underlying securities.
The group will reduce the volume of outstanding contracts through multilateral trade terminations. They also agreed to extend the changes in credit-default swaps to other derivatives contracts backed by equities, interest rates, currencies and commodities.
The group will provide details on its next steps by July 31, the Fed said in its statement. |
