CDS demonization watch, central-clearing edition

By Felix Salmon
February 29, 2012
Peter Eavis is too smart, and knows too much, to be writing disingenuous stuff like this, about Greece's credit default swaps:

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Peter Eavis is too smart, and knows too much, to be writing disingenuous stuff like this, about Greece’s credit default swaps:

If parties have to make good on the credit-default swaps, the situation could send shivers through the market. An important and long-planned measure that aims to strengthen the derivatives market is not yet in place, raising questions about how the financial system will react if the credit-default swaps have to pay out.

In the financial crisis of 2008, banks feared that their trading partners might not be able to meet such obligations on derivatives and other financial arrangements. The situation set off a chain reaction that paralyzed global markets until governments and central banks provided enormous financial support.

To prevent a similar disaster from happening again, finance ministers in the United States and Europe committed in 2009 to move derivatives like credit-default swaps onto clearinghouses. These organizations, if they work properly, can sharply reduce the chances that a large bank will not make good on such contracts.

There are lots of very good reasons why credit derivatives should be moved to exchanges — even though such a move is no panacea. But it’s silly to think that Greece in particular “could send shivers through the market” with respect to counterparty risk. Counterparty risk in the CDS market is highly correlated to jump risk — the risk that a seemingly-healthy company suddenly defaults on its obligations, causing a massive unexpected payout by anybody who had written protection on that name. In a case like Greece, where default is already priced in to the CDS market, there’s no jump risk at all, and anybody who has written protection has already posted enough margin that there shouldn’t be any problems at all.

More generally, the 2008 credit crunch was never related to worries over traded derivatives; it was — like all credit crunches — related to much more general worries over bank solvency and the quality of banks’ balance sheets. And in any case, the size of a bank’s derivatives obligations is unrelated to whether those obligations are settled bilaterally or centrally. If a bank has written so much credit protection that it becomes insolvent, then there’s significant systemic counterparty risk regardless of how its derivatives trades are cleared. Moving to an exchange might make its CDS counter parties more likely to get paid out in full, but it wouldn’t prevent other banks from refusing to do business with the insolvent bank, pulling their repo lines, and generally moving back in the direction of another credit crunch.

So the move to central clearing was never — could never have been — designed to prevent counterparty risk leading to a credit crunch. I welcome all wonky Peter Eavis articles about central clearing and why it hasn’t happened yet. But I’m very disappointed by this attempt to tie the issue into the Greek default in particular, which is entirely unrelated to the central-clearing issue. More generally, I think it’s a bad idea to sell central clearing as a potential means of preventing another disastrous credit crunch: it could never live up to that billing. It’s a perfectly good thing even if it doesn’t have such mythical abilities.

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