Exchange system approved for Credit Default Swap mess

The government finally approved an exchange for trading Credit Default Swaps. With so many financial institutions, from banks to hedge funds, holding on to these things, the question has been how to finally close out all these trades. A lot of the issuers can meet their obligations on these trades, and a lot of buyers of CDSes tied up a lot of their capital into these instruments. Everyone wants out, but there hasn't been an exit until now.

Frankly, I'm glad we're going to have an exchange, it should have been done this way from the beginning.  Everyone's stuff will be in the open, let the various market participants do this, not the government.  I would rather these folks close out their trades between themselves than having the government buy them and deal with it.  Also, this will open the way for a future Credit Defualt Swap product that would be more fungible.

Below is a news item from the CME Group website about this:

CHICAGO, March 13 /PRNewswire-FirstCall/ -- CME Group, the world's largest and most diverse derivatives exchange and its associated joint venture, CMDX, today announced that they have received a special exemption from the U.S. Securities and Exchange Commission (SEC) for clearing and trading credit default swaps (CDS) through CME Clearing and the CMDX platform. With this exemption, CME Group and CMDX have completed the regulatory reviews necessary to launch CDS clearing and trading in the U.S.

 

The SEC exemption allows CME Group to use its existing clearing membership structure to offer CDS clearing services backed by CME's industry-leading financial safeguards package of approximately $7 billion. Clearing members that are registered FCMs or Broker-Dealers will be able to clear CDS trades on behalf of their qualified customers. CME Group will utilize its robust portfolio-based margin methodology for determining index and single name margin requirements.

 

"We are pleased to have successfully completed the U.S. regulatory review process," said CME Group Executive Chairman Terry Duffy. "We are confident our significant financial safeguards package and the proven counterparty risk management framework of CME Clearing, which has protected investors across a range of financial instruments more than 100 years, can bring stability to the CDS market."

 

"As the CDS market migrates to a central counterparty clearing model, participants will benefit from the financial strength and risk management capabilities of CME Clearing - the largest derivatives clearing organization in the world," said CME Group Chief Executive Officer Craig Donohue. "CMDX and CME will offer the most complete CDS solution for all market participants, providing segregation of customer funds and positions, and the broadest product offering, including all major CDS indices and single-names."

 

An open solution for CDS products, CMDX will use the proven clearing, settlement and risk management capabilities of CME Clearing. CMDX provides straight-through processing to CME Clearing through CMDX's migration utility, trade booking facility and trading platform. CME Group will also provide CDS clearing services to market participants who submit trades directly or via inter-dealer brokers or other execution venues.

 

With the SEC exemption, CME Clearing and CMDX can now offer market participants key benefits that are distinguished from today's OTC market and other clearinghouses. These distinguishing characteristics include:

 

 

  • A time-tested legal and regulatory framework that protects both customer positions and margin. In the event that a CME clearing member was to default on their proprietary positions, all customer positions and collateral will be fully protected.

  • A state of the art clearing, settlement and risk management solution that provides significant improvements over the existing OTC CDS infrastructure.

  • A mutualized guaranty fund of approximately $7 billion, which provides unmatched protection for market participants

 

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this sounds very positive but how exactly

Does this limit the numbers of CDSes per one underlying asset? Does the "margin" imply the issuer of these CDSes must have funds in this account in the case of an underlying asset default?

So, if they do not have the funds to cover all of their issuances, what happens? They go bust but are now all of the CDSes worthless?

JV help us out here.

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Not an "exchange," and irrelevant anyway

This isn't an exchange, it's a central counterparty (CCP). CME Group operates other exchanges, but this isn't one of them. Exchanges and CCPs are fundamentally different entities.

In any event, the SEC already approved the main CCP for CDS (ICE Trust), and it's been clearing CDS for a couple weeks now. CME Group is irrelevant, and I doubt it'll ever get any volume. ICE Trust has the backing of the major dealer banks, so it will dominate the clearing of CDS.

Also, central clearing doesn't have anything to do with "closing out" CDS trades. It just substitutes the CCP as the counterparty to both sides of an already-agreed-upon trade.

And what makes you think "everyone wants out" of CDS trades? That's not even remotely true. If anything, everyone wants into CDS trades, because they're the best way to hedge credit risk, and because the CDS market was literally the only market to remain reliably liquid during the post-Lehman panic selling.

Finally, the idea that there "hasn't been an exit [for CDS trades] until now" doesn't even pass the laugh test. Of course there's an exit: just call your counterparty and buy out the risky PV of the remaining coupon stream. Happens every hour of every day. Or just buy an offsetting CDS.

Seriously, think before you type.

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JV his criticism looks valid here.....

care to respond?

anonymous drive-by Nick, I hope you consider creating an account. EP is a community site which means if you wish to write posts you can by creating an account. Sounds like you have some insight here into these CDS trades we could use.

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This isn't an exchange, it's

This isn't an exchange, it's a central counterparty (CCP). CME Group operates other exchanges, but this isn't one of them. Exchanges and CCPs are fundamentally different entities.

You are correct it isn't an exchange in the normal sense.  But before I decided to reply to you, I made some phone calls to both exchanges and their respective clearing corps.  As for the exchange, well allow me to break some news for you, the CME and ICE plan on making it a full fledged exchange for these swaps via their respective platforms.

In any event, the SEC already approved the main CCP for CDS (ICE Trust), and it's been clearing CDS for a couple weeks now. CME Group is irrelevant, and I doubt it'll ever get any volume. ICE Trust has the backing of the major dealer banks, so it will dominate the clearing of CDS.

First let me say it does not matter to me who "dominates," I own shares in ICE (CMEG at $256 a share is too rich for me), so the question on this is actually irellevent.  Who will have the lion share of this market though isn't clear cut.  Remember when the London International Financial Futures Exchange (LIFFE, now Euronext LIFFE) used to dominate in certain interest rate products then the Frankfort-based Eurex ate their lunch?  I will say this, there is something of an animosity or competition between New York and Chicago's financial markets.  Chicago has come to dominate derivatives markets in the US, and this is New York's chance to take a piece of the action; ironically enough ICE has offices here and is headquartered in Atlanta.  The CME has gotten big, especially after it purchased it's long-time rival the old Chicago Board of Trade; for many it seems as if they were "too big."

You stated volume, well the CME's thing just got off the ground, give it time. Saying that, and in the spirit of fairness, they are having issues.  Bloomberg has a story where the CME is having problems lining up customers. But we'll see if they get some.  Now, after talking with both on the phone, the ICE version has 7 dealers while the CME is looking to have more than this.  It should prove interesting how that turns out. Also, if it looks like they can get a better deal at the CMDX they will go to it, and there is nothing that says that Goldman or JP won't also operate there as well.  But like I previously state, it remains to be seen and it doesn't matter which one dominates; may the best platform win.

Also, central clearing doesn't have anything to do with "closing out" CDS trades. It just substitutes the CCP as the counterparty to both sides of an already-agreed-upon trade.

Where did I say central clearing did this?  I've never stated they closed anything.  Please re-read what I typed.

 And what makes you think "everyone wants out" of CDS trades? That's not even remotely true. If anything, everyone wants into CDS trades, because they're the best way to hedge credit risk, and because the CDS market was literally the only market to remain reliably liquid during the post-Lehman panic selling.

I was referring to positions where the counterparty is bankrupt and gone. I also never stated that people weren't looking to initiate new positions. Credit Default Swaps do make an excellent hedge, where did I make the opposite claim?  Also, no one is arguing about liquidity here. 

You seem to think that I meant that the sky was falling on CDSes, and if that is what you got from what I typed, then I should have said it better.  I've long promoted Swaps.

Finally, the idea that there "hasn't been an exit [for CDS trades] until now" doesn't even pass the laugh test. Of course there's an exit: just call your counterparty and buy out the risky PV of the remaining coupon stream. Happens every hour of every day. Or just buy an offsetting CDS

Trust me, no one is laughing.  Once more, you assumed that I'm of the opinion that the whole thing collapsed.  But you have a lot of these CDS where the payout isn't happening.  If it was such good working order, then why the hell is the CME and ICE even doing this?  If Goldman and JP Morgan were able to do this on their own, they would have.  Just because you can get a quote on a Bloomberg terminal doesn't mean you're going to trade at that price. 

You know, I find it humorous that you had to go on to attack me because I posted a news article.  Perhaps I was to broad in my message, I will grant you that.  But nowhere did the idea of derivatives as a bad instrument come into what I typed.  You seemed to be into derivatives like I am, and I look forward to seeing more posts from you.  But at least lets be gentlemen about this.

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in the great sea of spin and bullshit

yes please folks be civil and logical. It's tough enough to get to the truth on this financial Medusa, mud slinging will just make it worse.

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The problem with CDSs

Is the problem I see with *all* financial products- they aren't products. They're just paper- invented ideas. They're kind of like software in that way, but they're even less because software instructs machines to create wealth- financial products just tax wealth creation. We'd be better of segregating the financial industry into their own little sandbox and not letting them mess with REAL wealth creation, which while small in comparison (GWP is only $71 trillion or so, compared with the quadrillions WASTED on the financial industry) is at least doing useful work.
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Liquidity, Trasnparency, Exchange.. lipstick on a pig..

Credit Default Swaps are an abomination that should be put back in the "never again" category. Bucket shop laws worked fine for almost 100 years and should be reinstated. Also, as I read the CFMA, they are still illegal for individuals. Do we need a financial sytem based on transactions for which individuals would be prosecuted? (Not sued, prosecuted)

CDS are not a means to hedge risk. They are a means to obfuscate and distribute risk. People involved in the real world that add value to real stuff that people actually willingly pay for understand that avoiding systemic risk is all about avoiding the single point of failure, having redundant systems, etc.. The "financial services industry" (as we no longer seem to have banks, brokers, and insurers) in its infinite wisdom decided that all risk could be hedged, much of it "negative basis" and "money good". What they managed to do was create massive interdependence -- a big Rube Goldberg machine where the slightest hiccup creates a cascading disaster.

Consider mortgage backed securities on NINJA loans. Would YOU have been clamoring for a package of those? Me either.. The demand for mortgage backed securities was high because CDSs produced a high yield negative basis trade. If CDS "protection" was not available, most of the worst loans would never have been made. Investors were clamoring for the guaranteed high-yield securities, and as soon as it became apparent that many of the "guarantees" were worthless, the "liquidity" of the MBSs evaporated. Without CDS, there never would have been any "liquidity" for bad mortgages.

I'm all for hedging, but this isn't a hedge, it's a completely separate transaction that has nothing whatsoever to do with the underlying asset, unlike ANY other form of hedge tat I'm aware of, save interest rate swaps, but that's quite different.

Some have described CDS as equivalent to put options -- they aren't. Had the MBS CDS investors bought puts instead, they would have had to purchase the securities to exercise the options, and they'd have been hard pressed to buy more than exist. The biggest difference, however, is that after exercising the puts, the put seller would own the securities -- representing actual mortgages against actual houses which have value. Even though the sub-prime loans are nowhere near 1% of all mortgages, the houses are still worth 80% of the loans. So.. considering there were never more than about $600 billion in sub-prime loans and way less than $100 billion are actually in foreclosure, how could you have possibly lost more than $100 billion?? This should have been a financial hiccup.. You just can't come anywhere near systemic catastrophe without credit default swaps.

So, while you can rationalize 100 contributing factors and 50 ways to "improve" the situation, the fact remains that these things didn't exist 10 years ago and we had a perfectly functional financial system. If CDSs never existed, we wouldn't be in this mess. Done.

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Anonymous Drive-By Bill

This is a great comment and I have a tendency to agree with you on the system of systemic risk. If one does not isolate each component for potential failure, such as the way CDSes are structured, which as I understand it, are independent to the underlying asset and also have unlimited issuance....
so maybe it even incentivized, as you point out, more bad mortgages, for in that case (I don't know if this went into pricing here) the pay out on a bust is huge, with no downside in owning the asset.

I hope you create an account (upper right). EP is a community blog and forum, which means you can write a forum or blog post on CDSes (or any economic related topic as long as it has cited references, based in economic reality).

Great comment. Also, people CDSes have been in existence about 12 years or so.

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actually they are kinda like puts

There are Calls and Puts traded indices like the SPX or the NDX which are cash-settled options.  So in a way a Credit Default Swap is like a Put. 

 

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But as Anonymous Drive-by Bill pointed out

You can get a CDS on a security without buying the security- you can't get a Put on a traded index without owning the index, can you?

Then again, the more I dig into these so-called "financial products", the more my scam meeter goes off.

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You can't "own" an index

These are cash-settled options. There are no shares of an index to "own". So, no.

But, when you write an option contract, your broker will have margin requirements, limiting your ability to write an unlimited number of new contracts. I think this is something that the CDS market lacks.

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That to me

Makes cash-settled options *almost* as scary as CDSs. Good thing they have some limits on them.

Of course, to me, the proper use of money is direct investment in wealth creation- seed in the ground, mining equipment, and the like. Pure financial products scare the shit out of me.

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There's nothing to be scared of

There's nothing inherently scary about options(cash-settled or not) or CDS's. They are both methods of hedging against or speculating in risk. They're both essentially insurance. The problem with CDS's is, no one was required to carry adequate capital reserves to cover their potential obligations.

Or, more accurately, the financial models used to calculate what constitutes "adequate capital reserves" was seriously flawed. Firms ended up carrying far more risk than they thought.

CDS's depend upon the ability to forecast the likelihood of default, a rare and relatively unpredictable occurrence. It's hard to price them accurately. Options, on the other hand, are much more easily priced, as they depend on the far more predictable movement of the underlying index.

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CDSes are scary

Finding out more about how they are precisely calculated in terms of "premiums" would be useful to know.

But they allow unlimited issuance on one underlying asset. That's a serious problem. Maybe by requiring 100% capital reserves kept might keep them bounded.

Also, they appear to be created based on the probability assumption defaults are independent events. That's just plain wrong by the mathematics. Foreclosures, mortgage defaults are not independent events. Not only can they occur in regional clusters but also increase per originator, they are time dependent, labor markets dependent, a host of other dependencies as well. Most assuredly not an independent variable.

But even more odious is just how many CDOs are using the CDS data instead of historical raw data, to determine their value. That is just beyond stupid for CDSes have only been in existence since about 1996. Also, as far as I know they exist only in the U.S. or certain countries? It's not a global metric by any stretch.

To me, immediately all of those CDOs should be decoupled from CDS data. They should be isolated, possibly recalculated using raw histogram statistical data. (Just one issue on a host of thousands).

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CDS Problems

But they allow unlimited issuance on one underlying asset. That's a serious problem.

I don't think this is a problem, so long as there are adequate capital reserves to back up those CDS's (which is not currently the case). In the end, it doesn't matter if there are $500 billion worth of CDS's covering $5 million worth of bonds, as long as there is enough capital kept in reserve to pay out the $500 billion upon default.

You are absolutely on the mark though, about the inadequacy of the formulas used to calculate the price and risk of these instruments. Sadly, because of the complexity of the economy and the relative simplicity of current financial mathematics, there may be no way to correctly judge the risk or value of a CDS.

A 100% reserve requirement would have certainly prevented the current chaos in this market. But, then there probably wouldn't be a CDS market to begin with; it simply wouldn't be profitable to offer them for sale.

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we're barely scratched the surface

on all of these "structured financial products" but my impression is they created fictional mathematics purely to generate fees on ficitional bets.

I'm still digging around in it but they mask a lot of disclosure with advanced mathematics (ahem) which on much of it, I am like, where the hell is the financial mathematics community, where are the mathematicians calling these things out? If I can see the fatal mathematical flaws well, I know there has to be mathematicians who can easily see them also. where the hell are they?

You bottom point, if they have to back these things up 100% the entire market would probably not exist.....Q.E.D.

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Except of course

That reserve requirement, in and of itself, means less money is available for growing food, building houses, researching new medicines, investing in green energy, etc.
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Money makes it possible?

I don't know about you, but I've never found money itself to be any good for any of those purposes. Farmers grow their food from seeds, and carpenters build houses from lumber. Reserve requirements don't remove any real resources from the economy. Besides, with a 100% reserve requirement there wouldn't be any CDS market to begin with. People would just find other ways to hedge their debt exposure.

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Money buys the seed, pays for the food

Allows the lumberjack to feed his family. That's what money is really for- making sure your citizens can get what they need to survive.
Right now- we've got WAY too much of the available money tied up in these fake "financial products" that do no good for anybody. We've got people starving on the streets because they don't have enough money to survive. We've got citizens living in tent trailers because they've been foreclosed upon and priced out of the housing market.

Let's make sure everybody has their first level Maslow needs met before we go making people rich, ok?
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Here's what is really scary to me

I've long been a firm believer in "Technology, if nothing else, will make the lives of our children better than those of our parents". But insurance, and other risk hedging methods, cost money that should be going to R&D or other forms of real wealth creation. In the long run, you cause greater risk by limiting your risk, because you're removing funds from the *real* wealth creation the world needs to continue to survive, squeezing farmers out of the land market to build skyscrapers so to speak- thus making EVERYBODY much more poor than before.

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Insurance

Insurance is a necessary precondition for technological advancement. When we passed the technological point where we needed multi-billion dollar research facilities, decade-long research time-lines, and decades of production before the research costs are returned, we have needed insurance to hedge against the multitude of risks involved in advancement.

Even farmers are huge beneficiaries of hedging. The futures market allows farmers and food processors to lock in prices well in advance of the harvest, eliminating the flood of produce hitting the market at one time, and reducing the risk (and higher consumer prices resulting from that greater risk). Modern farming, with its resulting abundance, would be impossible without some form of insurance.

Unhedged risk increases costs for everyone. Insurance, in its more traditional form or options, reduces the risk associated with doing business, and reduces the cost to society. Eliminate insurance and you will raise the costs.

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Or the other way

Insurance is a necessary precondition for technological advancement. When we passed the technological point where we needed multi-billion dollar research facilities, decade-long research time-lines, and decades of production before the research costs are returned, we have needed insurance to hedge against the multitude of risks involved in advancement.

Or we do things the other way- by actually diversifying our investments so that if one investment goes down, no big deal.

Even farmers are huge beneficiaries of hedging. The futures market allows farmers and food processors to lock in prices well in advance of the harvest, eliminating the flood of produce hitting the market at one time, and reducing the risk (and higher consumer prices resulting from that greater risk). Modern farming, with its resulting abundance, would be impossible without some form of insurance.

Of course, there's also another way to do that- set cost+ pricing. Instead of letting the free market set the price of goods, let the manufacturer do it and take the risk that nobody will buy at the price that allows him to make a profit. Since the price is set by the farmer's costs, he can't lose money on the deal.

Unhedged risk increases costs for everyone. Insurance, in its more traditional form or options, reduces the risk associated with doing business, and reduces the cost to society. Eliminate insurance and you will raise the costs.

I'm not so sure that the cost of managing the insurance company hasn't totally swamped that benefit at that point. One could also say that paying protection money to the mob reduces the risk of getting your property hit, but in the long run, it's a losing proposition.
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Risk mitigation

Or we do things the other way- by actually diversifying our investments so that if one investment goes down, no big deal.

The only investments that can be called "our investments" are those undertaken by the government. Other than that, there are only "my investments", "your investments", and "his investments". Diversification is not a cure-all. Many small business owners have no way to diversify, all of their capital is tied up in that business. Farmers literally "bet the farm" on each year's harvest. And corporations focus their efforts toward their core competencies. They need some form of insurance, as it makes no sense for these people to diversify away from the areas where they are strongest.

I'm not defending the current state of the CDS market. It is a shameful example of hubris and shortsightedness. But, in order to have a modern and efficient economy, there must be some way to transfer risk to those who are most willing and able to bear it. That is what insurance does.

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And what I'm saying

The only investments that can be called "our investments" are those undertaken by the government.

And what I'm saying is that perhaps we need an entirely different system- where investment is done by the government alone, since the markets seem to be unable to actually handle risk.

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Complicit Government

What makes you think that the government (which was complicit in the entire CDS debacle) is any more able to manage risk than individuals?

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Government done right

Backs up their risk with military power, which is forbidden to individuals.
Of course, that's sovereign government, or government by and for the people. Government purchased by corporations works somewhat differently because corporations would rather change the laws to eliminate risk rather than actually *USING* the results of risk.
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