October 20, 2009 3:00 am

A stronger infrastructure will cut CDS vulnerability

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Financial innovation can bring an essential contribution to growth and prosperity. But it can also create significant instability. To reap the benefits of innovation and reduce its risks, we need robust and resilient financial systems and infrastructures. At Pittsburgh, G20 leaders have also called for more extensive regulation.

Credit Default Swaps (CDS) are a case in point. A recently published report by the European Central Bank, based on intensive quantitative and qualitative work performed by Eurosystem central banks* with the contribution of the industry, highlights two important features of the CDS market.

First, the market is increasingly concentrated between a small number of institutions. In Europe, two thirds of banks' CDS exposures are concentrated on their 10 largest counterparties. Worldwide, five banks - two of which are based in Europe - account for half of the CDS market.

This concentration has increased since the beginning of the financial crisis, as several major counterparties have exited the market. Players outside the banking sector, such as hedge funds, now account for less than 10 per cent of all CDS trades. Such a level of concentration is a factor of vulnerability, a risk for the liquidity of the market and a threat to efficient pricing.

Another interesting feature is the interconnected nature of the CDS market. In fact, not only do leading CDS players trade primarily among themselves, but they also increasingly exchange guarantees against their own default: six out of the 10 most traded contracts on non-sovereign entities are in fact guarantees on the very same CDS dealers.

In other words, dealers are guaranteeing dealers on a risk incurred on the dealers' community. This circularity implies that the transfer of risk has become more limited than expected.

Taken together, concentration and "interconnectedness" amplify counterparty risk and the potential systemic consequences of a default by one major market participant. This is why authorities have vigorously promoted the clearing of CDS by central counterparties (CCPs).

The G20 Pittsburgh statement sets a clear direction and deadline: all standardised derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate and cleared through central counterparties by the end of 2012 at the latest.

Currently, most of the CDS market is organised through OTC contracts, where buyers and sellers contract and settle bilaterally.

Market resilience depends, therefore, on the solidity of a dense and complicated network of bilateral relationships. Such a network is only as strong as its weakest link. By contrast, a CCP reduces counterparty risk through multilateral netting.

However, even in CCPs, counterparty risk never disappears. Clearing houses concentrate the risks and remain vulnerable to a default by a major participant.

They should operate under appropriate oversight in order to ensure that they are properly capitalised, maintain robust risk management practices and high standards of governance.

They must also not be dependent on liquidity provision by other financial intermediaries, which means they should have access, at any time, to central bank liquidity.

One sensitive issue on CCPs relates to their location. Here, two remarks can be made. First, the size of the market creates room for several CCPs to operate simultaneously with sufficient liquidity. Indeed, a monopoly by one CCP would increase systemic risk and deprive the financial system of the benefits of healthy competition.

Second, once a central bank is required to act as a liquidity provider to a CCP, it naturally wants to be in a position to have direct oversight responsibility over this infrastructure.

Both considerations, taken together with the volume of CDS contracts denominated in euros, explain why we consider it essential to establish CCPs in the euro area.

Transparency of the CDS market should also be enhanced. Data warehouses, because they hold the register of all positions, are key players in that respect: whatever their location, they should provide supervisors and regulators with access to all the data they need to conduct effective macro and micro-surveillance.

With both a stronger market infrastructure and greater transparency, we will be in a good position to insure that CDS provide a safer contribution to the financing of the economy.

* Credit Default Swap and Counterparty Risk, ECB August 2009. Banque de France contributed significantly to this report.Christian Noyer is governor of the Banque de France.

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