Sudip Bandyopadhyay’s Blog

There may be no end in sight to the financial crisis, but one consequence is already clear: over- the-counter markets will never be the same again. The crisis has brought complex structured financial products out of deep obscurity and exposed their weaknesses.  In particular, credit derivatives – which allow investors to make bets on the creditworthiness of baskets of corporate debt – stand accused as an accomplice in the meltdown.  Bad mortgage debt was at the heart of the credit crunch but, in the eyes of many observers, banks’ inability to quantify their exposure through credit default swaps (CDSs) the main kind of credit  derivatives, aggravated the crisis, while swings in the CDS market exacerbated the plunge in bank stocks.

CDSs allow investors either to bet on the chance of a debt default or to protect themselves from that risk.  One party pays an annual fee to another, in exchange for a promise that it will be compensated in a default.  The CDS market has experienced explosive growth, expanding by 81 percent last year to a value of $ 62,200 bn.  Although the sector has shrunk since then, it is so large that outstanding contracts are often 10 or more times larger than the underlying “cash” bonds.  Credit derivatives contracts are predominantly negotiated “over the counter”  - privately between traders in banks, rather than on a central exchange.  Because it is private, the decade-old sector has been largely unsupervised.  While CDSs have been hugely profitable for financial institutions, the lack of regulation and opacity have proved to be the market’s Achiles heel.

The absence of a central clearer has made CDSs risky because there is no guarantee that parties will pay out.  As the Counterparty Risk Management Policy Group, a taskforce of specialist bankers, has noted, a Central Clearing Counterparty (CCP) would “create a shock absorber” that would reduce the impact of default by a big participant.  In North America, CME Group, the world’s largest futures exchange, looks likely to be first off the mark.