Single-name credit default swaps help investors manage risk, but the 2023 financial crisis showed how these opaque derivatives can suddenly throw financial markets into turmoil. Randy Priem argues that mandatory central clearing, which some authorities have suggested as a solution to managing this risk, is not the holy grail solution they believe it to be.
The banking crisis of spring 2023 thrust into the limelight among bankers and investors a rather opaque financial derivative and the risks it poses to the financial system: single-name credit default swaps (CDSs). Some regulators are now pondering how to reduce the systemic risk from CDSs, including imposing a mandatory clearing obligation on them. This recommendation could resolve many issues that CDSs pose to financial markets but may do more harm than good due to the nature of the derivative.
Single-name credit default swaps are financial derivatives between two counterparties that allows one investor (i.e. a corporation, bank, or sovereign entity) that has purchased a financial instrument (e.g. bond) of a reference entity to “swap” or transfer the risk that the financial instrument seller defaults on their payment. The buyer of the CDS, also called the “protection buyer,” makes a series of payments to the “protection seller” until the maturity date of the financial instrument. Meanwhile, the seller of the CDS is contractually held to pay the buyer compensation in the event that, for example, the reference entity defaults on payment. Single-name CDSs are mostly traded in the over-the-counter derivatives markets, typically on confidential, decentralized systems, and have a total global value of around $4 trillion.
The terms of the contract are negotiated between the two counterparties, thereby making these contracts tailored to their preferences. Although counterparties in a CDS trade can choose the content of the contract they set up or the definitions of credit events they use to trigger contract liquidation, the vast majority of CDS trades use the definition of credit events developed by the International Swaps and Derivative Association (ISDA), such as a bankruptcy, an obligation acceleration, an obligation default, a failure to pay or deliver, or a repudiation. Note, however, that the ISDA master agreement is not a mandatory contract but is used voluntarily and may be altered by the counterparties, making not all CDSs standardized derivative contracts.
Why did the question to centrally clear CDS pop up again?
In March 2023, three small-to-mid-size American banks (Silicon Valley Bank, Silvergate Bank, and Signature Bank) ran into financial difficulties that spilled over to Europe, where Credit Suisse needed to be taken over by USB. Holders of the $17 billion risky Credit Suisse bonds were not part of the rescue deal, and investors were left empty-handed, which contributed to fears that investors in other European banks might lose investments in their bonds.
During that turmoil, European Union banks’ CDSs rose considerably. For instance, Deutsche Bank’s CDS price rose from 55 basis points on March 8, 2023, to 250 basis points on March 24, 2023. For Deutsche Bank, there were even more than 270 CDS transactions for a total of $1.1 billion in the week following the announcement of UBS’s takeover of Credit Suisse on March 19. This represented a more than four-fold increase in trade count and a doubling in notional value compared with average volumes of the first ten weeks of the year. The CDS market is typically illiquid with only a few transactions a day for a particular reference entity, so this increase in trading volumes was exceptional. On March 28, 2023, the press reported that regulators had identified that a single CDS transaction referencing Deutsche Bank’s debt of roughly EUR 5 million, conducted on March 23, could have fueled the dramatic sell-off of Deutsche Bank’s equity on March 24, causing its share price to drop by more than 14%. Hence, an illiquid market with relatively small deals could have exerted a heavy impact on share prices.
After the turmoil in March 2023, Andrea Enria, chair of the supervisor board of the European Central Bank, argued that central clearing for CDSs would improve post-trade transparency and reduce the risk of volatility. This highlights the question of whether mandatory clearing will solve the problems one observed in March 2023. Single-name CDS contracts can be cleared voluntarily at clearing houses, such as the French CCP LCH, Clearnet SA, or the U.S. CCP ICE Clear Credit LLC, but 50% of client gross exposure in the single-name market remains uncleared by Q2 2023.
A mandatory clearing obligation in the U.S. and Europe is not in place because the U.S. Securities Exchange Commission does not mandate clearing obligations of single-name CDSs and the European Securities and Market Authority does not consider the market liquid enough. The goal of this article is to determine whether mandatory central clearing of single-name CDSs should be recommended to legislators on both sides of the Atlantic.
Benefits and disadvantages of central clearing of CDSs
By acting as an intermediary between buyers and sellers, central counterparty clearing houses (CCPs) help to mitigate counterparty risk by guaranteeing the terms of the trade even if one party defaults. In addition, the CCPs are able to reduce risk by pooling exposure by the novation (substitution of an old contract with a new one) of bilateral contracts to make the CCP the buyer or seller in each contract. Whereas Party A would have sold a CDS to Party B, Party A now sells the CDS to the CCP and the CCP sells it to Party B.
Because of the CCPs’ multilateral netting activity, the number and value of outstanding settlements (i.e. asset deliveries and accompanying payments) between different parties decline, lowering the market’s overall credit exposure and also the amount of collateral needed. By minimizing the potential impact of a single participant’s default, central clearing contributes to overall financial stability. Furthermore, because central clearing requires more margin (collateral) compared to bilateral clearing, as well as more transparency, it prevents counterparties from taking on excessive risks.
However, there are also numerous arguments for why not all, especially the illiquid non-standardized single-name CDSs are suitable for central clearing or why central clearing would have disadvantages for CCPs or market participants. Installing a mandatory clearing mandate for single-name CDSs could increase systemic risk by importing exposures into the CCPs, which might be difficult to manage in a stressed environment. The cost of using a central counterparty can also be expensive for parties because of the higher margins requirements. The high margin requirements could even prevent certain smaller market participants from having access to clearinghouses, as not all investors can afford to set aside a non-negligible amount of capital as a contribution to a default fund.
Furthermore, the introduction of clearing fees may increase bid-ask spreads (the difference between the price a seller is willing to sell a contract (the CDS) and what a buyer is willing to pay) and decrease trading volumes. That is, clearing fees decrease the profits of dealers for providing liquidity and they may therefore increase bid-ask spreads to remain constant in profits per trade. In addition, dealers could respond to higher-order-processing costs due to increased margins by widening bid-ask spreads, which reduces the attractiveness of the CDS market for end-users.
Another reason why central clearing might not be recommended is that, although ISDA master agreements are used often, many CDSs are not standardized because buy-side firms tailor their contracts to their specific hedging needs, thereby reducing their level of fungibility. The absence of standardization leads to the absence of reliable and tradable prices that are necessary for a CCP to calculate the daily mark-to-market requirements. That is, for a CCP to determine, for example, its margins, capital reserves, fee standards, and default fund contributions, the contracts will require highly standardized terms, not only in terms of pricing but also to assess the total risk. CCPs need to perform a valuation of the instruments they clear to calculate the margin requirements or applicable haircuts and need to make sure that they can also be liquidated in case of a clearing member default. In the case of illiquid instruments, such as CDSs, this process is difficult.
Conclusion
This article concludes that, although mandatory clearing would have many benefits, such as fewer counterparty risks and more transparency, most single-name CDSs are too illiquid, not sufficiently standardized, and too opaque to be suitable for mandatory central clearing, at least in the short term. They would lead to a considerable prudential risk to CCPs without the latter being able to provide many multilateral netting benefits.
Author’s Note: The author is the coordinator of the markets and post-trading unit at the Belgian Financial Services and Markets Authority (FSMA). Views expressed in this article are those of the author and do not necessarily reflect the views of the FSMA or any other institution with which the author is affiliated.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
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