Investment banks eye CDS clearing house

by Dave Nixon

Story link: Investment banks eye CDS clearing house

Deutsche Bank and other investment banks are working on strategy to develop a clearing house for the credit derivatives markets in an attempt to calm growing regulatory and investor fears about “counterparty risk”.

Specifically, the banks are trying to develop a format that would only allow institutions with sturdy capital bases and credible trading histories to clear trades in the credit default swap markets with a central counterparty.

A CDS provides a kind of insurance against corporate default and is extensively used to grow a trading exposure to moves in a company’s credit quality.

The flippantly regulated CDS market is bigger than the US government bond and housing markets combined.

Nevertheless, there have been growing worries following the implosion of investment bank Bear Stearns that troubles among some counterparties could devastate trades across the market and create broader systemic jeopardy.

The labors to create some structure of clearing house are coalescing around the Clearing Corporation, a group that is mutually owned by 11 leading banks, such as Deutsche Bank, Credit Suisse, Goldman Sachs and some other trading platform providers.

These discussions mark a prominent new twist in the development of the credit derivatives industry that has lacked any central clearing system and has intensely resisted any suggestions that banks should move their current private or “over-the-counter” trading activity on to regulated exchanges.

The proposals to build this type of clearing house are set to be tremendously contentious within the industry, not least because some bankers fear it could presage an eventual shift towards greater regulation of the CDS sector.

Some senior Wall Street figures are now warning that, if the industry does not swiftly act to tackle this counterparty risk issue via the creation of a clearing house or other mechanisms, it could be forced to accept higher regulation – or shift its activity into an exchange.