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By Ronald Fink
A new study of the credit-default swap market suggests that regulatory proposals to move standardized contracts to exchanges or clearinghouses won't do as much as anticipated to improve transparency in the market.
The study, put out by research firm CreditSights this week, suggests that far fewer contracts than expected would move to the exchanges or clearinghouses than proposed legislation envisions, because there isn't enough liquidity in securities of the companies or other entities that swaps are written against.
That would leave those swaps to trade along with customized ones in the over-the-counter markets, as they do now. The resulting opacity of the market, whose total face value at its height last December reached $62 trillion, helped trigger the failures of Bear Stearns, Lehman Brothers, AIG and much of the rest of the financial crisis.
Swaps accounting for only about a third of the $32.3 trillion in notional value of the contracts tracked by the Depository Trust & Clearing Corp. are sure to be traded on exchanges or through clearinghouses, noted the CreditSights study. That's because half represent single-name entities instead of indexes or tranches of indexes. And there's very little trading in many of the securities of those single-name entities. The top two entities, for instance, are the republics of Italy and Turkey, followed by J.P. Morgan Chase, according to the analysis of DTCC data.
"Liquidity for a single-name entity can change unexpectedly," wrote Atish Kakodkar, an analyst for the research firm, noting that that "could complicate the move to a clearinghouse." Kakodkar added that "we believe there will be plenty of single-name contracts that clearinghouses will be reluctant to clear given liquidity constraints."
The analyst observed that regulators would have to come up with ways that the OTC markets could "mimic" trading on the exchanges or clearinghouses to deal with standardized but illiquid swaps.
Not coincidentally, perhaps, the Commodities Futures Trading Commission issued proposed rules yesterday that would offer added bankruptcy protection for holders of OTC derivatives.
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