Friday, April 18, 2008

Investment banks eye CDS clearing house

(Gillian Tett and Paul J Davies in the FT) Deutsche Bank and other investment banks are working on plans to develop a clearing house for the credit derivatives markets in an effort to allay growing regulatory and investor fears about “counterparty risk”.

In particular, the banks are tying to develop a scheme that would only allow institutions with strong capital bases and credible trading histories to clear trades in the credit default swap markets with a central counterparty.

The aim is to ensure that members of this clearing house club would be more protected from the risk of a trader or investor failing to meet their obligations.

A CDS provides a kind of insurance against corporate default and is widely used to gain a trading exposure to moves in a company’s credit quality.

The lightly regulated CDS market is bigger than the US government bond and housing markets combined.

However, there have been growing fears following the implosion of investment bank Bear Stearns that problems among some counterparties could wipe out trades across the market and create broader systemic risk.

The efforts to create some form of clearing house are coalescing around the Clearing Corporation, a group that is jointly owned by 11 leading banks, such as Deutsche Bank, Credit Suisse, Goldman Sachs and some other trading platform providers.

These discussions mark a striking new twist in the development of the credit derivatives industry that has lacked any central clearing mechanism and has fiercely resisted any suggestions that banks should move their current private or “over-the-counter” trading activity on to regulated exchanges.

The proposals to create this type of clearing house are set to be extremely controversial within the industry, not least because some bankers fear it could presage an eventual shift towards greater regulation of the CDS sector.

Some senior Wall Street figures are now warning that, if the industry does not swiftly act to tackle this counterparty risk issue via the creation of a clearing house or other mechanisms, it could be forced to accept higher regulation – or shift its activity into an exchange.

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