Is there an alternative to exchange-traded CDS?

By Felix Salmon
March 19, 2010

I just had an interesting conversation with a senior market participant about the optimal way to structure and regulate the CDS market, compared to the proposal which has now been put forward by Chris Dodd. Essentially, there are two options here: you can either consolidate all the different functions (trading, matching, confirmation, clearing, information warehousing) onto a handful of big global exchanges — or you can disaggregate those functions and allow competition in each of them separately.

It’s pretty obvious that the exchanges, especially the big ones like the CME Group, would love to see everything consolidated with them* (Update: The CME says this isn’t true, see below.) And they’re in luck: that’s exactly what we see in the Dodd bill. I’m sure that makes for happy pillow talk in the Dodd household: Dodd’s wife, Jackie Clegg, is a director of the CME, which paid her $153,219 in 2009; she also owns shares in the company worth about $235,000. (The CME makes no mention of her husband on its website or in its SEC filings, despite the fact that he’s surely a big part of the reason why she has the position.)

That said, consolidating on exchanges is a relatively simple and elegant solution. The alternative is to allow a number of different companies to compete at each stage in the process: trading platforms (Tradeweb, MarketAxess, that kind of thing); matching and confirmation services like ICE Link; and clearing and settlement companies like ICE Trust or LCH.Clearnet. Once all that was done, all of the data would be aggregated into a common standard and warehoused at DTCC and possibly somewhere else as well; the systemic risk regulator would keep a close eye on all that data, and everybody else could too, since it would be made public in a form where new analytics could be applied to it very easily.

The risk with the exchange-based solution is that the exchanges will get protective over their data, and while they’ll surely show it to the systemic risk regulator, the risk regulator will be the only one aggregating the data, and it’ll be harder for the public to get access to it. And, of course, there will be a relatively small number of exchanges trading CDS; as such, the winners in that market — most likely including the CME — will probably end up making windfall profits off everybody else, thanks to their greater pricing power.

On the other hand, the risk with breaking up the different functions of the exchanges is that they’ll end up being dispersed around the country and the world, with the effect that many of them are likely to be pretty free of regulatory oversight. I’m not sure how much of a problem that is, if all the data is publicly warehoused, but conceptually it’s certainly easier for the SEC and CFTC to keep a close eye on the CME, and for their European counterparts to oversee Eurex, than it is for a disparate group of international regulators to try to keep up with a rapidly-evolving set of obscure market facilitators.

My feeling is that while I have no particular love for the exchanges, they’re clearly not part of the problem here, and that if they take over large chunks of the CDS market, little if any harm will be done. I would, however, ask them to report all their data to the DTCC for warehousing, and then require the DTCC to make that data available in a publicly-tractable form. It might not be the solution that today’s big CDS players most like — they’re likely to lose profits to the exchanges — but I’m not going to shed any tears for them. In theory, an alternative system might work. But in practice, moving everything to exchanges is much easier to grasp and implement.

Update: CME spokeswoman Anita Liskey tells me that “we don’t offer trading for CDS, only clearing services”, and sends over this statement:

“We do not believe that clearing should be mandated for all over-the-counter products because it exposes a clearinghouse  to undo risk.  In addition, many contracts do not lend themselves to central counter party clearing because of the complexity of their pricing.  We have publicly stated that mandated OTC clearing does not further the stated goals to bring transparency, integrity and stability to OTC derivatives markets.   Clearing should be encouraged through appropriate capital charges and tailored regulation for participating swap dealers.”

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