In light of recent bank failures, Electronic Platform for CDS is proposed

In light of recent bank failures, Electronic Platform for CDS is proposed

By: Ryan Van Parys

At the urging of the Federal Reserve and SEC, a hedge fund in Citadel and a clearinghouse in CME(Chicago Mercantile Exchange) group have announced a plan for a joint venture which would introduce the first electronic exchange for Credit-Default Swaps which would bring standardization and improved liquidity to a market which is in part to blame for the current financial crisis. The market currently covers $55 trillion in assets and has been in part responsible for the demise of financial giants such as AIG, Bear Stearns, and Lehman Brothers.

Credit-Default Swaps are derivative instruments which act as essentially insurance for defaults on issued bonds, mortgages, and other leveraged securities. If, for example, Bank of America were to default on their corporate bonds tomorrow, bond holders would not get paid (outside of collateral), but CDS holders theoretically would get paid some sort of premium. Likewise, if Bank of America does not default, then bondholders get paid and the seller of CDS securities also gets paid (think insurance company). However, CDS markets in current form are unregulated over-the-counter markets (OTC’s) where it is uncertain whether or not the seller of a CDS is backed by any collateral, making the investments highly speculative in nature. In addition to the complexities involving the actual issuing, the pricing on CDS securities is often even more cumbersome. Currently, there are very few standardized pricing agencies for CDS, since the securities are traded over the counter; and since the price includes risk from default from the company, contractual obligations AND default from the seller.

In addition to the bad debt that CDS swaps have presented, they have also become particularly harmful to both the bond and equity markets. When institutional investors wish to understand the likelihood of default by a company, they often look to the CDS markets to see what interest rates CDS policies are currently demanding. In the equity markets this often causes downward pressure on stocks(especially in the current market), and in the corporate debt market it forces corporations to offer higher interest rates when issuing debt.

The article discusses how CME group and Citadel plan on launching an electronic exchange in early November where investors can trade anonymously with the advantage of standardized contracts, regulated pricing, and a clearinghouse which will guarantee payment on CDS securities. The move from an archaic over-the-counter system with many problems to an official exchange which utilizes regulation through technology will hopefully bring more transparency and liquidity to a market which desperately needs it. In order to encourage activity, the exchange is offering up to 30% equity and the ability to become market makers for current large institutional investors already entrenched in the CDS business. The new exchange also hopes to partner with other clearinghouse and pricing groups in order to bring more liquidity and standardization to the market.

While the market seems like the right thing to do for the economy, it is unclear as to whether investors of CDS securities will actually participate. Since the market is currently unregulated, the OTC market makes it easier for large investors to manipulate spreads and often lead to higher returns. However, Citadel has a very strong reputation in the CDS market and could very well draw many of the big names to the exchange. Regardless, the Fed has set up a meeting with CME, Citadel, and other companies considering starting their own CDS exchanges to discuss progress within the upcoming weeks.

The exchange introduced by CME and Citadel utilizes information technology in a number of ways. First, one of the main issues with the current CDS market is its lack of transparency and inability to collect off of a bad debt. With a new, highly automated electronic exchange being implemented, it will make it much easier for buyers and sellers to collect on their debt which, in some cases, has been outstanding for years. Additionally, the technological platform will make it easier for liquid assets to flow as spreads and contracts will be more standardized and research will be easier to come by. Finally, the electronic exchange will help liquidity in the market by providing open access to more buyers and sellers through the exchange. This will bring more competition to a market which is currently very exclusive.

While I do believe an exchange for the CDS market is a step in the right direction, it is unclear to me as to why this market is not currently regulated by the SEC or even Congress. From the articles I have read, it seems that they are not regulated because they are simply so misunderstood. I find that inevitably hard to believe as there is currently over 55 trillion dollars in debt outstanding with a high percentage of that number in absence of collateral. I think the federal reserve would like to do something about cleaning up the market, and the implementation of an exchange seems to be the first step.

Main Article -- http://online.wsj.com/article/SB122334553812310351.html?mod=googlenews_wsj

http://www.247wallst.com/2008/10/what-a-cds-exch.html

http://www.forbes.com/markets/2008/10/07/cme-citadel-update-markets-equity-cx_cg_1007markets32.html