Centralising credit risk
When it comes to apportioning blame for the credit crisis, credit default swaps (CDS) are one of the targets. Fingers have been pointed in other directions, including Fair Value Accounting, but few would argue that CDSs have become something of a scapegoat.
Since the start of the credit crisis we have also seen a remarkable fall in the volume of credit default swaps. And although they have been central to the fall of AIG, which sold high volumes of CDSs, it would be foolish to blame the economic downturn on a single derivative instrument.
CDSs have been through many tests in recent months, with the collapse of Lehman Brothers and the Icelandic banks. But overall, the settlement of the CDSs has worked well. Where some purchasers have lost out, is in cases where their CDS counterparty has gone – a prime example being Lehman Brothers.
And this is the great fear in the market, that a big issuer of CDSs will be unable to meet its future obligations.
There have been some discussions recently about creating a ‘central counterparty’ for CDSs to act as counterparty for all credit default swaps. The European Commission has already asked financial market participants to come up with a blueprint for a central clearing house.
It should not only eliminate the credit risk an investor has to its counterparty, but more importantly, improve transparency.
A measure like this would be greatly welcomed, as the lack of transparency has been a defining characteristic of the crisis. In fact, it was the lack of transparency on CDSs and toxic mortgage backed securities that made the banks over cautious and stop lending to each other. If this works for CDSs we may also see other swaps, such as vanilla interest rate swaps, covered by the central counterparty. This would make it even more central to our economy.
But the introduction of a central counterparty will also create a new risk.
It introduces a systemic risk should the central counterparty ever get into trouble. This will probably not happen any-time soon and at the moment, all concerned parties are promising that the central counterparty will be well funded and backed up by solid risk management processes. Nevertheless, over time complacency sets in, as it did just like with Freddy Mac and Fannie Mae, the two giant mortgage insurers in the US.
It goes without saying that the central counterparty will have a de facto government guarantee as it will be too big and too important to ever fail.
And as things develop, margins will be lowered because ‘the risk management systems are very good’ and ‘previous defaults were well covered.’ Until the day when a new recession unexpectedly sets in and several previously good creditors default and create a domino effect, it will again be up to the governments to save the financial system and come rescue the central counterparty.
