By Neil O’Hara
In the debate about overhauling the financial system to prevent another collapse like last year’s, few subjects are as contentious as the $28 trillion credit default swaps market. It’s arcane, complex, secretive and immensely lucrative for both the banks that sell them and their biggest customers—hedge funds. Hedge funds use CDS for arbitrage plays and to take short positions, as well as for hedging their bond exposure. It was a great business until this past September’s Lehman bankruptcy and the ensuing $185 billion federal bailout of American International Group, a major player in the CDS market. Those events highlighted the fragility of a system run by a small clique with limited capital requirements, transparency and regulatory oversight.
At issue is how to corral these financial equivalents of the Wild West. As financial reform legislation begins to take shape, the consensus seems to hinge on mandating capital requirements for dealers and, at the least, settling some CDS trades through a clearinghouse financed by industry players. The Obama administration and legislators also want to encourage trading of standardized contracts on an exchange, an idea opposed by both banks and most hedge funds. Complicating the effort to fence in CDS is a competitive tussle over clearinghouses and uncertainty over how many contracts are standardized enough for clearing, let alone for trading on an exchange.
Instead of trying to regulate CDS, George Soros has suggested they should be banned altogether. Soros argues that CDS create incentives for investors to favor bankruptcy over negotiated capital reorganizations, and some in Congress seem to agree. Indeed, the most recent legislative proposals call for a ban on most naked CDS, which are those not used to hedge an underlying risk.
Such bans are unlikely to happen, despite the fact that the morass created by AIG’s bailout has made CDS regulation a high priority among lawmakers. And though taxpayer money kept AIG’s swap counterparties from losing billions of dollars (another sore point with the government), they didn’t fare so well in the Lehman bankruptcy, which has prompted the industry’s own calls for reform.
Consider the experience of Citadel Investment Group in Chicago. Its CDS desk had to scramble when Lehman went bankrupt September 15, 2008, frantically sorting out the firm’s exposure. The impact was brutal: Citadel’s Kensington Global Strategies lost 16.14% during September 2008, partly as a result of those CDS.
CDS depend solely on the judgment calls of market participants, who bear the risk of determining the creditworthiness of the parties with whom they do business. What makes hedge funds furious is that market practice requires customers to post collateral to protect dealers against customer credit risk. Dealers—such as Lehman and AIG—who were assumed to be sound, in part, because their derivatives affiliates were rated triple-A, don’t have to do so.
Contracts typically let dealers rehypothecate the collateral (mostly cash), which means they invest the money alongside their own capital to earn incremental returns. When Lehman failed, investors not only suffered mark-to-market losses but also lost access to collateral posted as initial margin, which became an unsecured creditor’s claim against the bankrupt entity.
While Citadel’s CDS desk turned chaotic as the Lehman bankruptcy unfolded, it was business as usual for the group handling Citadel’s futures, a derivatives market in which trades take place on an exchange and settle through a central clearinghouse. Lehman’s U.S. broker/dealer, which didn’t file for bankruptcy, continued to operate for a week, during which time customers were free to transfer their accounts to other firms. Later, Barclays Capital stepped in and bought Lehman’s U.S. customer business, and all the accounts that hadn’t moved—the vast majority—went to Barclays.
Citadel and other investors who traded futures through Lehman—a big Chicago Mercantile Exchange clearing member—never lost a dime on those trades from counterparty risk. The CME’s margin requirements ensured Lehman posted enough collateral to cover any potential losses. The robust multilayered guarantee fund (more than $7 trillion) that stands behind CME’s clearinghouse was never tapped—nor has it been at any other time in the exchange’s 110-year history.
“Investors never lost their positions or access to the market or their funds,” says Kim Taylor, managing director and president of the CME’s clearinghouse division.
Lehman’s bankruptcy galvanized efforts to create a central clearinghouse for standardized CDS. Clearinghouses, which are capitalized by their members, insure both sides against default by the other through a central guarantee fund. Requiring CDS to settle through clearinghouses is the proposal for reform both banks and hedge funds support. Right now, two candidates are vying for the dominant platform.
Citadel’s Lehman experience undoubtedly accelerated its efforts to enter into a joint venture with the CME to create CMDX,
a platform that will marry CME’s clearing expertise with Citadel’s trade matching and migration technology. CMDX has all regulatory approvals in place and support from hedge funds and other investors, but it hasn’t gotten off the ground because the dealers have so far refused to do business with it. Instead, they are backing ICE Trust, a clearinghouse affiliate of the Intercontinental Exchange the dealers helped design and finance. ICE has guaranteed more than $1.6 trillion in contracts since March, all of them with bank counterparties. Bank of America, Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Merrill Lynch, Morgan Stanley and UBS were founding members, later joined by Royal Bank of Scotland and HSBC. ICE Trust currently clears about 2.5% of the CDS market.
While the dealers appear to have a head start, their lead could be hampered by a Department of Justice investigation into anticompetitive practices in credit derivatives trading and information services. The DOJ, which has declined to comment, reportedly has sent notices to banks that own London–based Markit Group regarding possibly unfair access to price information.
Nine members of this same group—Bank of America, Barclays, Citi, Credit Suisse, Deutsche, Goldman, JPMorgan, Morgan Stanley and UBS—late last year started a lobbying campaign to oppose excessive regulation of CDS, including curbs on custom transactions and a mandate for exchange trading. To run it, the group, called the CDS Dealers Consortium, hired Edward Rosen, a partner at the law firm Cleary Gottlieb Steen & Hamilton, who worked with the banks in fending off regulation of the derivatives market a decade ago. The consortium paid him $290,000 in 2008 and 2009, according to the Center for Responsive Politics.
Soon after the banks began their lobbying effort, the first CDS regulation bill was introduced. In January, Sen. Tom Harkin (D-Iowa), chairman of the Senate Committee on Agriculture, Nutrition and Forestry, introduced legislation that would require all over-the-counter derivatives to trade on an exchange. Although hedge funds favor more regulation of CDS and are hardly in the same camp as the dealers, most vehemently oppose a mandated exchange solution. One leading hedge fund lobbyist goes so far as to predict that exchange trading would “completely kill the credit default swaps market.”
Exchange proponents believe that it’s the best way to limit the systemic risk that derivatives pose in their current form. “Exchange trading will be a major improvement in the transparency and efficiency and will foster liquidity by drawing in a wider range of speculators and liquidity suppliers,” said Richard Bookstaber, a risk guru who has worked for Wall Street firms and several hedge funds, most recently Bridgewater Associates.
In testimony before the Senate Agriculture Committee earlier this year, Bookstaber said that a centralized clearing corporation is a welcome step but doesn’t go far enough, because it won’t provide the same degree of standardization, transparency, price discovery and liquidity. And while he acknowledged that derivatives can improve financial markets, Bookstaber said that over time “derivatives found use for less lofty purposes” and have helped institutions “game the system” to solve noneconomic problems. Bookstaber added that “the main use of credit default swaps is to allow traders to take short positions on corporate bonds and place bets on the failure of a company,” the so-called naked CDS. As Bookstaber stated in his testimony, “noneconomic objectives are best accomplished by designing derivatives that are complex and opaque so that the gaming of the system is not readily apparent.” He argues that the main problem with derivatives is their complexity because it makes markets crisis prone. “We need a flight to simplicity.”
Market participants counter that exchange trading requires a degree of contract standardization that doesn’t yet exist as well as liquidity that only the most actively traded index CDS exhibit today. For example, it was only in February that the market adopted standardized coupons for North American CDS and while the convention applied to all future transactions, legacy trades cannot be converted to the new standard. The market still hasn’t coalesced around standard terms for market disruption and adjustment events, early termination provisions and other terms needed to make contracts fungible enough to trade on an exchange.
Clearing is easier to accomplish. Although estimates vary, the CME reckons that 70% to 75% of open positions in the market would be eligible for clearing at CMDX when it’s fully up and running. That would include the plain vanilla five-year term index products hedge funds like to trade.
Sam Cole, chief operating officer of BlueMountain Capital Management in New York City, a $4.2 billion hedge fund that specializes in credit, acknowledges that while exchange trading does bring incremental pricing transparency and often boosts liquidity, it has little effect on operational or credit risk beyond what central clearing offers.
Exchanges could never handle illiquid and customized CDS. But these aren’t suitable for clearing either. “You have to be careful putting nonstandard credit default swaps into a clearinghouse,” says Cole. “You don’t get the frequency or number of pricing points. It would be dangerous to concentrate risk that is not entirely measurable or transparent.”
BlueMountain, which specializes in arbitraging credit, stands to gain more from the clearing solution. In general, the more transparent price disclosure is, the less arbitrage is possible.
The firm was formed by Andrew Feldstein, one of the derivatives experts at JPMorgan, who developed credit derivatives to help banks cover the risks of the loans they were making in the early 1990s. BlueMountain recently profited from arbitraging CDS against underlying loans and bonds in basis trades. This year its flagship fund has earned more than $268 million, or about 11%, on such trades through April, the firm told investors.
If price transparency is desired, market participants say it can be done via electronic trading as well as an exchange. Darcy Bradbury, a former Treasury official who is now director of external affairs at D. E. Shaw, a $26.7 billion multistrategy hedge fund in New York City, points out that the entire U.S. fixed income market—Treasurys, agencies, munis and corporates—is cleared but trades OTC with screen pricing that lets investors see multiple quotes on a single page. The foreign exchange market trades the same way—and the CME’s 2006 attempt to shift spot FX trading to an exchange environment, FXMarketspace, shut down after 18 months for lack of investor support. “Ultimately, we’re less concerned with the forum than with our treatment as customers,” says Bradbury, “Our top priority is a smooth-functioning market with appropriate transparency, access and protections.”
Bookstaber agrees that OTC contracts that are standardized enough to support multiple bids and offers on an electronic trading system are almost as effective as an exchange. “It’s a continuum,” he says, “You could get to a tipping point where the end users require anybody who is acting on their behalf to use standardized or exchange-traded instruments.”
Some hedge fund managers do favor a shift to exchange trading, including Ari Bergmann, managing principal at Penso Capital Management, a New York City hedge fund that manages $400 million. “It is so much more efficient,” he says, meaning it’s more transparent, liquid and that the exchanges eliminate counterparty risk. “But it won’t succeed without the dealers. You have to give them incentives to trade on the exchange.” High regulatory capital requirements for off-exchange trades might do the trick, for example, but Bergmann also argues that anti-gambling statutes could be adapted to render off-exchange transactions unenforceable.
Bookstaber says exchange-traded derivatives by themselves will create hurdles for OTC derivatives, though he does not advocate their abolishment. “The OTC product will have worse counterparty characteristics, be less liquid, have a higher spread and have inferior price discovery,” he says.
The latest Congressional proposal has come from the House, where the Committee on Agriculture, chaired by Rep. Collin Peterson (D-Minn.), and the Committee on Financial Services, chaired by Rep. Barney Frank (D-Mass.), in late July agreed in principle to increase regulatory capital requirements against nonstandard contracts and to promote the use of standardized contracts that can be cleared and traded on an exchange. Their proposal also bans trading in naked CDS that aren’t used for hedging purposes, an idea that immediately drew fire from market participants who say it is impractical and unenforceable.
The Obama administration has been hedging its bets. In mid-July, U.S. Treasury Secretary Timothy Geithner endorsed both clearinghouses and exchanges when he testified before Congress: “We propose to require that all standardized derivative contracts be cleared through well-regulated central counterparties and executed either on regulated exchanges or regulated electronic trade execution systems.” Geithner acknowledged a role for customized contracts but plans to encourage migration to standardized forms through the regulatory capital regime just as the joint House bill will provide. He also opposed banning naked CDS.
If easing systemic risk is the goal of regulation, hedge funds say that central clearing mitigates almost all that in bilateral contracts provided that the clearinghouse has top-notch risk management, including stress tests, margin requirements and a sound guarantee fund. In addition, hedge funds—the largest buy-side traders of CDS—want the clearinghouse to segregate their initial margin deposits and provide portability of positions. “We think it’s critical to protect customer margin and to be able to move trades to another dealer in the event of a default,” says Bradbury. Bigger funds would like to become clearing members who can influence policy at the clearinghouse too.
CMDX piggybacks on the CME’s existing guarantee fund, so it has been able to set a lower qualification threshold for clearing members—$300 million, compared with $5 billion for Tier 1 capital at ICE Trust, which is building its guarantee fund from scratch. Clearing member default risk at CME Clearing is spread among firms that trade everything from pork bellies to equity index futures, while only the big CDS dealers will qualify as ICE Trust clearing members. ICE Trust is a bankers’ club that pools the risk among members of that group, most of which received federal stimulus money.
If—or when—credit default swaps do migrate to an exchange, CMDX should have an edge given the fact that the CME already has the exchange infrastructure in place.
ICE Trust is already operating, however, and the market may not have room for more than one U.S. clearinghouse. Paul Hamill, business manager for credit trading at Barclays Capital, notes that most other asset classes have gravitated to a single clearinghouse. It’s the most efficient model, because clearing members can post collateral at a single venue. “Having a single clearinghouse is operationally simpler,” says Hamill, “As you start bifurcating the clearing world you get a lot of margin inefficiency.”
CMDX proposes to clear more contracts than ICE Trust from the outset, including the CDX and iTraxx index products and their single-name components. So far, ICE Trust clears only selected series of CDX index products, although it plans to add iTraxx and single names in due course. Conceived as a dealer-only clearinghouse, ICE Trust, at first, did not satisfy hedge fund demands for segregation of margin or portability, either, although that is changing. The dealer participants are all represented on ISDA’s Operations Management Group, which, in a June 2 letter to William Dudley, president of the Federal Reserve Bank of New York, set a goal “to achieve buy-side access to CDS clearing (through either direct CCP membership or customer clearing) with customer initial margin segregation and portability of customer transactions no later than December 15, 2009.” On July 22, ICE Trust announced plans to open up to buy-side participants in October and “provide segregation of customer funds and positions, as well as enhanced position and margin portability.”
Dealer antipathy to CMDX reflects a struggle for control of the OTC derivatives markets. Opaque pricing fattens dealers’ profit margins, and they are reluctant to give up the cheap funding customers’ initial margin provides. Literally billions of dollars are at stake, according to Bookstaber. Lehman’s collapse shifted the balance of power toward investors, albeit with a strong assist from regulators. Long an exclusive dealers’ club, ISDA has now admitted D.E. Shaw and two traditional asset managers to its board. And when the Federal Reserve established a committee to review the various CDS clearinghouses, it invited eight dealers, four hedge funds and four asset managers, the first time the industry has seen such a collaborative effort. Whether it will lead to effective regulation of the CDS market is the unknown.
