Revisiting concerns in credit derivatives markets

When I first wrote the report raising concerns over Credit Default Swaps, people asked I don’t understand why will there be a crisis. Then there were a series of developments that raised similar concerns (here and here).

Now, in a recent testimony by Patrick M. Parkinson, a Deputy Director in Fed we get similar concerns. Though, he downplays the concerns but one can clearly see that there are number of issues with settlement and honoring of so many CDS contracts. And the testimony highlights NY Fed has been doing a lot of work to make the clearing and settlement systems, the crisis undid the entire good work.

Although these achievements were impressive, the financial turmoil during the summer of 2007 convinced prudential supervisors and other policymakers that further improvements in the market infrastructure were needed.  Specifically, CDS backlogs grew almost fivefold from June to August 2007, reversing much of the previous improvement.  Although the backlogs subsequently receded, this episode demonstrated that backlog reductions were not sustainable during volume spikes.  Moreover, it underscored that, in many respects, the post-trade processing performance of the OTC derivatives markets still lags significantly the performance of more mature markets and still has the potential to compromise market participants’ management of counterparty credit risks and other risks

Mr Parkinson also suggets exchange trade credit derivatives (ETCD) and establishing a central counterparty system to clear trades. He says ETCD is a good idea but:

However, they should not lose sight of the fact that one of the main reasons the credit derivatives market and other OTC markets have grown so rapidly is that market participants have seen substantial benefit to customizing contract terms to meet their individual risk-management needs.  They must continue to be allowed to bilaterally negotiate customized contracts where they see benefits to doing so.

This ETCD is being discussed in India as well after RBI put a hold to allowing credit derivatives. However, it will not be very easy to just have ETCD. OTC will also have to be allowed and this is where problems begin. It isn’t just about allowing the trading of CDS, you need to think about clearing and settlement as well. Somehow, most debates don’t cover this issue at all.

3 Responses to “Revisiting concerns in credit derivatives markets”

  1. Derivatives » Credit Derivatives valuations and pricing: Managerial level Says:

    […] Revisiting concerns in credit derivatives marketsMoreover, it underscored that, in many respects, the post-trade processing performance of the OTC derivatives markets still lags significantly the performance of more mature markets and still has the potential to compromise market … […]

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  3. Aluwani Mulaudzi Says:

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