Opinion

Felix Salmon

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:

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.

Comments
12 comments so far | RSS Comments RSS

Hear, hear. If there were any risk from Greece CDS it would be from its NOT trigger. Everyone has posted collateral to a 70 points upfront value. If it suddenly gapped to zero, *that* would be the riskier situation from a counterparty perspective. What’s more, if the market perceives that CDS does’t work, every bank’s reported sovereign exposure is unreliable. Talk about destabilizing! The only way to hedge sovereign exposure would be to sell sovereign bonds. Does the ECB want to really kick the SMP into high gear??

Posted by anonhfm | Report as abusive
 

Great points by Felix. Analogous to how the recent financial crisis was far from the first banking crisis triggered by the crash after a debt-fueled run-up in real estate prices, despite what a lot of commentators say.

Posted by realist50 | Report as abusive
 

Felix,
Thanks for discussing my story. I think you underestimate the importance of central clearing. Bank solvency and strength is hard for outsiders to gauge when non-centrally-cleared OTC derivatives make up a large part of the balance sheets of large, interconnected financial firms. If the Fed and other central banks hadn’t flooded the system with money in 2008, OTC derivatives could have caused far more damage than they did, so it makes no sense for some people to say that just AIG was the problem. Hence, the G20 was correct to make central clearing a priority in 2009. Now we are on the verge of large default, it makes perfect sense to link central clearing to (Greek) CDS. Will activating them lead to a systemic meltdown? There are no visible signs that will happen. But it seems reasonable to have expected central clearing to be in place by now. If it were, we wouldn’t have to just sit here and hope that the banks are sufficiently collateralized because they say they are. Financial regulation done well allows regular people not to have to take big banks at their word. It also protects the system against risks you can’t currently see. Europe may not be through with sovereign defaults. The Greek one has been stressful enough. CDS would certainly – and deservedly — become an issue of Italy ends up struggling under its debtload. So we should expect the system to be as girded as possible, especially three years after the 2008 crisis. Linking all this together hardly deserves the adjective “demonization,” my friend.
Best,
Peter

Posted by petereavisNYT | Report as abusive
 

Judging by his comment here, you have been rather too kind to Mr. Avis.

Posted by Greycap | Report as abusive
 

Are you sure there aren’t some 5-10 year old CDS exposures written back when people thought a Eurozone default was implausible?

My impressions of the CDS market were 1) it’s huge, 2) it mostly nets to zero, and 3)it’s so huge that even small percentage deviations from perfection have trillion-dollar consequences. Am I wrong here?

Posted by JayCM | Report as abusive
 

Eavis’s comment is completely vacuous. At no point in his rambling, incoherent response was he even close to anything that could be considered a rational thought. Everyone in this chatroom is now dumber for having listened to it.

Posted by pessimist2 | Report as abusive
 

Also, for reference, here’s what the G20 said in 2009, clearing fingering certain OTC derivatives as systemically risky:

“The recent financial crisis exposed weaknesses in the structure of the over-the-counter (OTC) derivatives markets that had contributed to the build-up of systemic risk. While markets in certain OTC derivatives asset classes continued to function well throughout the crisis, the crisis demonstrated the potential for contagion arising from the interconnectedness of OTC derivatives market participants and the limited transparency of counterparty relationships.

OTC derivatives benefit financial markets and the wider economy by improving the pricing of risk, adding to liquidity, and helping market participants manage their respective risks. However, it is important to address the weaknesses in these markets which exacerbated the financial crisis. To this end, building on the commitments set out in the Pittsburgh statement, the G-20 Leaders committed at the subsequent Toronto Summit to accelerate the implementation of strong measures to improve transparency and regulatory oversight of OTC derivatives in an internationally consistent and non-discriminatory way.”

Posted by petereavisNYT | Report as abusive
 

That is super what the G20 said, but that has nothing to do with Greece CDS. Greek CDS are a mess but that is mostly due to issues of deliverables and the bond swap.

The notionals are small, and the trades are typically collateralized. Can you point to anything that would make us think CDS will lead us a systemic meltdown?

Posted by pessimist2 | Report as abusive
 

Got to disagree about no one linking bank solvency to OTC derivatives. GS made a huge deal about being hedged with CDS against AIG. Maybe it was true, maybe not. If it was true, who knows who was on the other side of those trades and might have been taken down by a default. In the decision to blank-check AIG right after Lehman, derivatives and their impact on the system’s solvency were front and center. Even before that, there were a lot of concerns about whether the Lehman CDS would settle without a crisis. So, even though the CDS weren’t triggered for AIG and settled without major hiccups in other cases, OTC derivatives added a great deal to uncertainty about bank solvency. Central clearing and reliable exposure data would have mitigated that.

Posted by streeteye | Report as abusive
 

The comment by JayCM (above) and Coventry League’s blog titled “Derivatives: Collateral Posting Not Retroactive” are highly relevant. Some – many, evidently – continue the meme that CDS parties have already posted margin/collateral. Maybe; maybe not.

It depends on when the contracts were initiated and whether they are centrally cleared. If they were initiated, say, in early 2010, then ZERO collateral posting is required. Review Berkshire Hathaway’s $63B derivatives (note these are index derivatives). NONE require margin/collateral posting of the $10B+ that would be required if these contracts were initiated after mid-2010. This is just one small example.

As Coventry League said, we shall see…

Posted by Btherm | Report as abusive
 

The big banks generally require collateral posting on trades like these. BRK’s index trades are not relevant.

Even if the trades on Greece are done without margin, which is just not plausible, I find it hard to get around the fact that net and gross notionals aren’t that big. 3b net and 70b gross isn’t going to be doing much to the global economy.

http://www.dtcc.com/products/derivserv/d ata_table_i.php?tbid=6

Posted by pessimist2 | Report as abusive
 

Good Piece Felix-
Central Clearing is not a Panecea to what ails the Banking Sector. Its the rotten to the core balance sheets that are the problem. These banks need to open the Kimono so to speak and so far are unwilling to do so. They have skirted around openness and transparency via FASB regulations etc. There are only 2 ways to reign in the banks:
1-Bring down the leverage
2-Net Capital Rules.
This by itself will force bank balance sheets to shrink forcing the banks to get smaller.

Posted by JayTrader | Report as abusive
 

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