The existing bilateral trading arrangement for CDSs has proven itself a contributor to systemic counterparty risk. Without a central hub to assess real-time, system-wide risk and manage collateral requirements, outstanding CDS contracts must currently be accounted for in a siloed fashion. With the credit crisis continuing, the Federal Reserve is looking to the private sector for clearing solutions to lower systemic risk in the CDS space.
Exchanges CME/Citadel, ICE, NYSE Euronext and Eurex have responded to the call, and all hope to provide a counterparty clearing solution by way of an exchange model. The exchanges can be the watchful "eye in the sky" of firms trading at their venues, providing risk management and facilitating the efficient use of trading firm collateral. NetDelta, on the other hand, is proposing a counterparty clearing solution that does not rely on mutualizing risks. Whichever clearing solutions are adopted, they will work best for fungible, "vanilla" structures with widely followed underlying reference assets.
"In this rush for a solution to minimize systemic risk in the CDS space, market participants and regulators must be mindful of the different aspects of counterparty risk inherent in those solutions," says John Jay, senior analyst with Aite Group and author of this report. "The proposed solutions do not directly address legacy CDS positions and custom-made CDS structures. As such, with any trends toward standardized structures, dealer firms will need to weigh shrinking spreads against what they can make in more customized transactions."