Clearing up the credit swaps fog

Credit default swaps hardly used to be a subject to keep people awake at night. No longer. Designed as insurance for a company’s creditors against its default, issuance of such derivatives exploded in recent years. But transparency failed to keep pace and the bankruptcy of Lehman Brothers last month turned into a nightmare for global finance.

Largely unfettered by regulation, the $58,000bn market evolved with over-the-counter transactions. The absence of a clearing house, where trades are recorded and cleared, has now come to haunt investors.

When Lehman defaulted, the total amount of CDS on its debt was unknown. Estimates suggested that as much as $400bn might have to be paid out. That would have had the potential to cripple even the biggest banks, and may have added another element of fear to already panicky markets. While banks could work out their own exposure, neither they nor regulators could be sure what other banks owed.

To make matters worse, Lehman was itself a writer of CDS and other derivative contracts. The bank’s collapse rendered them void and left protection buyers scrambling for new hedges. Counterparty risk – ignored in the good times – was back with a vengeance.

A clearing house, which many hope to be in place later this year, would have addressed both concerns. By assuming counterparty risk, it centralises and renders transparent this risk. Moreover, trades are offset – or netted out – across institutions. Individual net positions are known and credibly covered by collateral.

The Depository Trust and Clearing Corporation, where most CDS trades are registered, now estimates that only about $6bn need physically change hands next week when Lehman CDS are settled. The vast majority is netted out, and systemic risk appears marginal.

Had this information been available widely days instead of weeks after Lehman failed, the extreme cash-hording of banks and distrust in each other’s balance sheets might have been less severe.

The importance of a clearing house in alleviating counterparty risk was shown by LCH.Clearnet, the clearing house for interest rate derivatives. Within days, Lehman’s $9,000bn contracts had been wound down successfully.

Allowing an opaque market to grow unchecked was an inexcusable oversight of regulation. It must not be repeated: clearing houses for CDS are coming belatedly; others, such as for interbank lending, should follow. Investors may finally get some sleep, but regulators must knuckle down.