Reinventing the Credit Default Swap: CDS on CCP

By | October 20, 2010

Also posted at TabbFORUM and JLN Interest Rates.

Whatever you think of credit default swaps after the financial crisis and global recession that ensued, they did have some worth: people who bought them were protected against what turned out to be real risk “credit events.”

So what if we were to take their intrinsic value and lay that over what’s rapidly developing in the OTC derivatives market today?

To wit: OTC derivatives clearinghouses act as an outsourced risk management department for market participants who use them. Rather than managing the counterparty risk internally via collateral and other mechanisms, clearinghouses mitigate counterparty risk for its members via margin requirements, guarantee funds and other tools in their decades-old toolkit.

Clearinghouses, however, though built with the sole purpose of reducing risk, do not completely eliminate risk for OTC derivative transactions.

By the nature of the clearinghouse model, clearinghouse member firms are still left exposed (although less so) to other member firms.

But perhaps even more importantly, members are exposed to the clearinghouse itself. What if the clearinghouse fails? To that point, the New York Times recently published an article that called clearinghouses “the next too big to fail.”

The last few years (hopefully) have taught us to never say never. Regardless of how unlikely they are to occur, systemically risky events can’t be ignored and must be mitigated. So although clearinghouses are built to never fail (they are not investment banks after all, and don’t seek to take on risk), an economic calamity no one has yet to think of could indeed cause the unthinkable.

So what’s a market participant to do? Dealers today use credit value adjustments (CVAs) to hedge the risk that their counterparty in a bilateral OTC derivative deal fails by adding a few basis points to the cost of the trade for the buyer. Among other things, this CVA calculation takes into account the current CDS spread for the counterparty to predict the potential loss due to counterparty risk.

But theoretically, this practice is unnecessary in the centrally-cleared world since there is no risk that a counterparty will default. But that’s not really the case. Enter the CDS on CCP.

I’m no financial engineer, quant, PhD or trader, but I’m quite sure one of the aforementioned individuals can find a way to create an instrument to hedge the risk of a clearinghouse default. So why not a CDS on the CCPs?

We already have CDS on U.S. Treasuries (the ultimate too big to fail, right?) so it only seems logical. Maybe even a CDS CCP Index product that hedges against the risk of any CCP in the world failing.

Alas, the idea creates a huge paradox however – who’s going to clear them?

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