Dealers in credit derivatives are being urged to “tear up” some of the outstanding trades that could pose a potential risk to the financial system as part of renewed efforts by US regulators to improve the crucial sector’s infrastructure.
Efforts to tackle operational inefficiencies in the infrastructure underlying the notional $62,200bn market for credit default swaps, which is lightly regulated, have taken on a fresh urgency because of the credit crisis, and is likely to draw more scrutiny in coming months.
In particular, the collapse of investment bank Bear Stearns has heightened regulator concerns about “counterparty risk” and sparked new worries about the ability of dealer banks to manage a surge in trading volumes when markets are highly volatile.
The majority of trades for CDS, which provide a kind of insurance against corporate default, are done between banks.
Estimates suggest tens of thousands of trades “offset” each other and could be eliminated or “torn up” either on a bilateral or multilateral basis.
Robert Pickel, chief executive of the International Swaps and Derivatives Association, said the “tear-up” process or “portfolio compression” was a part of “good housekeeping”. He added: “Both firms and regulators are in favour of this and tear-ups can be done bilterally or multilaterally.”
However, he emphasised that the process was only one element of a number of changes being discussed over the way over-the-counter derivatives trades are processed.
“There is a desire on the part of market participants to address these issues themselves and not have new regulatory solutions imposed on them,” he added.
Last week, the New York Federal Reserve met banks, hedge funds and other market participants to outline changes in a number of key areas, including a reduction of outstanding contracts, establishment of a central clearing house, and greater automation of trading and settlement.
Conducting more “tear-ups” is seen as a complementary step towards the establishment of a central clearing house for credit derivatives. Indeed, the growing emphasis on managing the counterparty risks inherent in OTC derivatives is reflected in the growing pool of cash posted as collateral on such trades.
“Trading OTC derivatives creates counterparty risk,” said Colm Gaughran, global product head for JPMorgan’s derivatives collateral management business. “This has been highlighted by the credit crunch. Before, some people thought of collateralisation as an inconvenience. Now, people realise it is your main and often only source of protection against counterparty risk.”
