The cost of trading credit derivatives is expected to be higher than dealers thought before last week’s collapse in confidence in the financial markets and the seizing up of the credit markets.
In particular, dealers said they were expecting regulators to impose higher margins on trades in credit derivatives once the central counterparty is established. The margins will be used to fund the counterparty guarantees offered by such a clearing house, which may also require upfront capital payments.
“Discussions about margin levels are taking place as we speak,” said a senior banker involved in the talks. “We are assuming regulators will impose higher margins, which dealers will then have to pass on to their clients, like hedge funds. It is another way to reduce leverage in the financial system.”
Dealers and investors are still trying to establish the scale of losses related to Lehman’s collapse, the first time one of the large counterparties in the derivatives industry has gone under. The final figure for losses is expected to feed into discussions about how much it will cost to trade credit derivatives in the future, according to regulators and bankers.
Credit derivatives, a sector that has ballooned to $62,000bn worth of contracts in just a few years, has been a huge source of profits for dealers and investors.
The higher costs related to counterparty risks could make it less profitable in the future.
The Federal Reserve Bank of New York has been pressing dealers to improve the trading and settlement infrastructure around the credit derivatives market.
Dealers have agreed to make changes by the end of this year, including setting up a central counterparty.
Dealers said that, a week into the Lehman bankruptcy, they were about “half way” through closing out trades with Lehman. Investors such as hedge funds have much more cumbersome processes to work through, as they often require numerous quotes for each derivative they are seeking to unwind.
Previous discussions about a central counterparty met with some opposition from hedge funds and other investors, with some investors worried that a small group of dealers would have too much control over the sector.
There appears to have been a shift in sentiment, however. “There is a widespread recognition that there needs to be change. Credit derivatives are very valuable tools and we need to find a way to make the market more sustainable in the future,” says one leading hedge fund manager.