Credit Derivatives, Crises, and Clearing Houses

To bring order to chaos in group activity, it is not uncommon to suggest a clearing house, i.e., a vehicle for sharing information to improve coordination. The recent financial crisis provides such an opportunity, as market regulators and participants call for a clearing house in credit derivatives (CDs) to help them assess systematic risk exposure and interlinkages. Clearing houses exist in many established financial markets, and they unquestionably contribute to the stability of these markets. What are they and how do they work?

In the stock market, the trades reflected in the published volume figures are not by any means completely accomplished by the time the day’s volume is reported. These trades are best viewed as preliminary agreements between buyers and sellers. The process by which the terms of these agreements are verified, payment is made to the seller, and ownership is transferred to the buyer is called “clearing and settlement.”

Anyone who has bought or sold a house can attest to the protracted complexity of the steps leading up to the final settlement. The process in financial markets is usually much more streamlined and efficient. In the US stock market, clearing and settlement takes three days. The clearing house is a business (the Depository Trust and Clearing Corporation, or DTTC) to which brokers send their trade information. The DTTC takes over clearing and settlement of the trades, constantly communicating with the brokers to verify and inform.

The DTCC also provides this function for CDs. It collects trade information, computes payments, and arranges for them to occur. The DTCC registry can in principle allow us to figure out the extent of CDs written on a particular company, and to disentangle the credit exposures of the market participants. In practice, obstacles remain. First, the DTCC’s registry is not comprehensive. The notional value of (i.e., the value of underlying debt insured by) all CDs is about $55 Trillion, while the amount registered at the DTCC is only about $35 Trillion. So we get at best an incomplete picture.

More significantly, though, the DTCC registry can only tell us who owns what. It does not tell us what the CDs are worth. The DTCC is not a market and has no prices to report. This lack might seem surprising. In a stock trade, the DTCC arranges for payment. It therefore knows the transaction price. Given the short time frame, this is a good estimate of the stock’s current market value. Since the DTCC performs the same function for CDs, why doesn’t it possess similarly reliable estimates for their market value?

There is a fundamental difference between traditional securities (like stocks) and derivatives (including CDs). In the usual stock trade, at the end of three days, matters are completely finished. The buyer has the stock; the seller has the payment; there is no need for any further communication. Transactions in derivatives, however, are not so neatly resolved. Options, futures and swaps (including credit derivatives) carry with them potential payment obligations that extend over their maturity, possibly many years. For a CD the DTCC can compute the payment currently due, but not the payments that will arise in the future. The expectations of these future payments are the main determinants of the CD’s value.

In the absence of a reliable market price, might the DTCC still provide transparency by independently verifying the terms of a CD and firms’ positions? The complexity of CDS agreements makes this difficult. Witness the recent weekend marathons of financial engineers seeking to value the swap books of Bear Stearns and Lehman.

For an exchange-traded derivative (like an agricultural futures contract or a listed stock option), even though the clearing house is not by itself a market, it helps sustain the market and thereby produce reliable prices. The futures or options clearing house accomplishes this, though, by filling a more expanded role. Specifically, it effectively guarantees that the buyer and seller will fulfill their eventual payment and delivery obligations. With this guarantee in place, each side of the trade looks to the clearing house, rather than the original counterparty to the trade. In this sense, the clearing house “steps in the middle” of each trade. The protection goes far beyond what is offered by the DTCC registry.

In order to make this guarantee, the clearing house imposes obligations on market participants. It requires them to post funds (margin) and it forces them on daily basis to realize profits and losses that would otherwise accumulate “only on paper”. It imposes position limits, ensuring that no single trader can dominate the market. Interestingly, it also discriminates between hedgers and speculators, imposing stricter terms on the latter. (In terms of the CD market, someone buying default insurance on a bond he owns is a hedger, while someone making a bet on a “credit event” with no ownership stake is a speculator).

Are margins, position limits and daily resettlement necessary in over-the-counter derivative markets (like CDSs)? There are significant costs involved. These would be borne by hedgers as well as speculators. But it is clearly time to ask if the societal value of the risk-sharing facilitated by these products in normal times justifies the costs they impose when the market breaks down. A clearing house that merely tabulates the bets taken does not seem to go far enough.

Originally published at Stern on Finance on Oct 21, 2008 and reproduced here with the author’s permission.

2 Responses to "Credit Derivatives, Crises, and Clearing Houses"

  1. DuncanL   October 25, 2008 at 5:40 am

    An exchange would indeed probably make day-to-day trading of CDS easier and smoother – but I don’t see much evidence that this has really been the problem we are facing. It is much less clear to me that an exchange would be helping us now, as defaults pick up, or would have avoided the problem.For a start, and from a slightly technical perspective, the initial margin amounts that would be posted would have been based on relatively small price moves – anything else would make the CDS funded, ie a bond and the exchange would not attract any business. Now imagine a low spread company jumps to default – there would not be enough marign in the exchange to protect from counterparty risk. Now the prospect looms that the exchange actually increases systemic risk.Secondly, and probably more fundamentally, the problem we have on our hands is that people extended too much credit at too low a price – with the help of credit derivs. One possible cause of that was that everyone was trading for short term gains from smallish price moves and didn’t think about correlated defaults. To my mind moving to an exchange would only encourage short-term trading mentatlity and would not help us get back to backing that up with more fundamental credit analysis.

  2. Guest   November 4, 2008 at 3:01 pm

    You have a good point there. But I think that the most outlandish risk transfers would be priced more correctly and make them obsolete from the start.