What A CDS Exchange Means To Debt Issuers & To You

There has been talk of creating a central exchange and clearing mechanism for the widely unknown and illiquid Credit Default Swaps, and now that talk has materialized into an actual effort.  The requirements for trading and the sizes of contracts still needs to be worked out.  But the CME Group (NYSE: CME) and Citadel Investment Group have now entered into an arrangement to launch a joint venture for an electronic trading platform integrated with a central counterparty clearing facility for these instruments.  What is more important than the news are the ramifications of this new exchange.  We have taken a very simplified and general approach to this in order to explain how this can ultimately impact corporate America and ultimately the average investor.

CME and Citadel executed a non-binding term sheet on Tuesday to launch a jointventure company within 30 days.  This will also be the first integratedCredit Default Swaps market and CME will act as the centralcounterparty.  This venture will have its own board of directors andmanagement team.  Current CDS market participants have beeninvited to join as founding members and the exchange is allocating upto 30% of the equity in the venture.  It is also offering certainmarket maker privileges to founding members to encourage participantsto migrate existing positions and to trade new contracts on theplatform.  This new joint venture has also entered into preliminarylicensing discussions with Markit, which is one of the financialinformation services companies that owns widely traded CDS indices andindustry-standard CDS identifiers.

But what does all of this mean?  Credit default swaps areessentially insurance against the failure to repay debt orprotection against an entire default of obligations.  CDS’s can evenprotect against rating downgrades and more.  The problem today is that there are nottruly liquid open exchanges where the public can see what ishappening with credit spreads.  Some even believe CDSmarkets can be manipulated rather easily.  During the malaiseof last week, credit default swaps were at levels never seen.  That ispart of why great firms such as General Electric (NYSE: GE) and GoldmanSachs (NYSE: GS) were having to pay up substantially forcertain capital raises in recent days.  That is also one of the reasonswhy Warren Buffett’s Berkshire Hathaway (NYSE: BRK-A) was able tocapitalize on the current situation.

The current market is not perceived as being full of standardized contracts andstandardized terms.  This new venture aims to standardize the contracts.  Theexisting trading is frequently done on spreads, and depending upon howyou interpret its wording this new market aims to do this with fixedcoupons for all the leading CDS indices and their underlyingsingle-name components.  This new market also will come with OTC marketconventions, including credit event procedures.  Considering that the CDS market islisted as a $45 trillion market in mid-2007 (International Swaps &Derivatives Association figure), you can see where a centralmarketplace and standardized terms would be helpful.

Since these are essentially over-the-counterderivatives (OTC Derivatives), there is also counterparty risk in each transaction beyond normal market risk.  In an environment where banks do not even wantto lend to each other overnight, that becomes a serious issue.  If, andit is a big "if," this is pulled off, then the actual counterparty riskwill become much less reliant upon individual trading partners.

CME has a well established clearing, settlement and risk managementgroup.  Citadel has become known as a strategic investor with hightechnology capabilities.  This may also be true of existing mechanismsfor trading CDS’s, but the case against their liquidity andeffectiveness today is mounting.  It might be a bit premature tosuddenly get the old hypothetical "AAA" spreads back to 35 basis points over treasurieswith the spreads of "A" at 60 basis points and 100 basis points for"BBB" ratings (all hypothetical, but more historic than today’s crazyspreads).  But it will at least set the stage to normalize andstandardize these spreads.

In short, What happens if the cost of buying default insurance againsta debt issuance is 500 basis points?  Essentially that means that theissuer has to pay a full 5% more to borrow so that the borrower isprotected against default.  Add in the risk that the borrower is alsotaking on the counterparty risk of dealing with another firm, and itgets more complicated still.

A standardized exchange will at work towards pricediscovery. It can’t be expected to work overnight, but it is betterthan what is currently available.  A new exchange will also allow forCME clearing to reducing bilateral credit risks.  Thatwill set the bar for capital requirements and higher trading in and outof positions.

Over the recent weeks there has become a sudden and sharp need toreduce counterparty credit risks in the CDS market.  This breakdown has been largely one of the major causes for the inabilityfor companies to raise capital.  If you have to pay 10% to raisecapital and you have negative margin today or operate at 9% margin,then you have to go for leverage.  That doesn’t work in a de-leveragingenvironment.

One other aspect it will fill is making for more transparency in theregulatory environment.  We have been told how many regulators do notunderstand the risks in many OTC derivatives, including in CDS terms.Whether or not that is a norm or an exception is still an unfinishedchapter.  But the fewer variables and the more transparencies thatexist, the more liquid these instruments will become and the easier they will be able to be monitored for risk management and regulation.

It is highly unlikely that grandmas and auto workers will start makingcredit spread bets.  It is highly unlikely that you will have boilerroom brokers pitching these to the public.  But there is at least achance now that the hundreds of regular participants who have to accessthis market and the potentially thousands of outlying participants willbegin to have the resemblance of something that looks more and morelike a traditional liquid market.  Some have argued that it is alreadyefficient even keeping these as OTC.  But the actions taken in recentweeks have probably thrown that out the window for some time.

This is still subject to completion of definitive agreements andnecessary regulatory approvals.  If this CDS Exchange really comes to fruition, the ultimatecost will be lower borrowing costs and more liquidity for the companiesand entities which need to borrow funds for normal operations.  Thatwill also make it easier for investors to actually analyze the risks ofinvesting in companies.

Now they just have to survive and make it work.

Some of the data from early this year is already outdated because evolution takes placeso quickly now, but Time warned of this being the "next" next thing toworry about earlier this year.  Investopedia also some has some good brief background materials on this and related topicsif you want to learn more about these derivatives.

Jon C. Ogg
October 8, 2008