Chapter 11: Executive Summary – Centralized Clearing for Credit Derivatives

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section IV: Derivatives, Short Selling and Transparency

Background

Credit derivatives, mainly Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDOs), have been under great stress during the sub-prime financial crisis and have contributed significantly to its severity.  In large part this is because these relatively new products are traded in bilateral transactions over-the-counter (OTC), unlike other major financial derivatives that are traded on exchanges.  OTC contracts can be more flexible than standardized exchange-traded derivatives, but they suffer from greater counterparty and operational risks, as well as less transparency.

Chapter 10: Executive Summary – Derivatives – The Ultimate Financial Innovation

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section IV: Derivatives, Short Selling and Transparency

Background

Derivatives are financial contracts whose value is derived from some underlying asset. These assets can include equities, bonds, exchange rates, commodities, residential and commercial mortgages. The more common forms of these contracts include options, forwards/futures and swaps. A considerable portion of financial innovation over the last 30 years has come from the emergence of derivative markets. Generally, the benefits of derivatives fall into the areas of (i) hedging and risk management, (ii) price discovery, and (iii) enhancement of liquidity. Even in the current financial crisis, the derivative scapegoat, credit default swaps (CDS), has played some positive roles. For example, CDSs enabled lenders to hedge their risk and offer loans. When the securitization market for loans, bonds and mortgages shutdown in the summer of 2007, a number of financial institutions were left holding large loan portfolios. Using the CDS market, some of these financial institutions smartly hedged out their risk exposure. In addition, CDSs and other credit derivatives have played a very important role in disseminating information to both the public and to regulators: from judging the quality of financial firm’s bankruptcy prospects in a remarkably prescient way, from providing credit risk estimates that were central to the U.K. government’s bailout plan, and from revealing in early 2007 declines in values of subprime-backed assets.