Wire: BLOOMBERG News (BN) Date: 2009-01-29 00:55:46 U.S. Draft Law Would Ban Most Credit-Default Swaps (Update1) (Adds Dinallo estimate in fifth paragraph.) By Matthew Leising Jan. 28 (Bloomberg) – A draft bill circulated in Congress that would change how over-the-counter derivatives are regulated might ban most trading in the $29 trillion credit-default swap market. House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota unveiled an updated draft bill today that would prohibit credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the $684 trillion over-the-counter derivatives market to be processed by a clearinghouse. “This would basically kill the single-name CDS market,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. “Given the small size of many issuers’ bonds outstanding, this would make it practically impossible for the CDS market to exist.” U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the OTC markets to improve transparency amid the credit crisis. Bad bets on credit-default swaps led to the U.S. takeover of American International Group Inc. in September. As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo last year proposed outlawing so-called “naked” credit-default swap trading. He shelved the proposal in November because of progress by federal regulators on broader oversight of the market. ‘Bad Idea’ “It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down,” said Robert Webb, a finance professor at the University of Virginia and a former CME trader. “This is a bad idea.” Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them. As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanley comes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t set, said Bruce Weber, a finance professor at the London Business School. Interest-Rate Swaps JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion, according to data from the Office of the Comptroller of the Currency. Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America. The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market. The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21. A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared. Adding Stability Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer. The standardization necessary to process a contract in a clearinghouse, however, could harm the market and drive the trading overseas, Weber said. “It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses,” he said. “It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction.” Weber said that if price transparency is what Chairman Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on how the size of positions held by OTC traders. --With reporting by Shannon D. Harrington in New York. Editors: Alan Goldstein, Michael Nol
Dont see this ever hapenning…just another case of a stupid politician who doesnt understand the marketplace getting a little ahead of himself
I didn’t read the whole thing carefully, but it’s clear that CDS is a kind of insurance and may need to be regulated as insurance, with proof of reserves, reinsurance policies, etc… What happens is that the presence of this insurance makes people take extra risk thinking they aren’t exposed to it, but the sum of all risk taking may lead us to a place where the correlation assumptions that make the insurance seem workable all of a sudden fall apart, and now everyone is exposed. So I expect CDSs to be regulated more like insurance contracts eventually.
agree with bchadwick. I think they will be around, but more regulated/transparent/exchange-clearing house driven
What wouldn’t happen to all the outstanding CDS where holders didnt have the deliverables? Unravelling that mess would not be pretty But I agree on the clearing house and more regulation end though just not this politicos idea…the head of the agriculture committee!!! Where does he get off…
These trillions of dollars in credit default swaps (CDS) should be declared null and void. These “swaps” are simply bets that financial instruments and companies will fail, and the bulk of the bets are made by people and institutions that do not hold the financial instruments or shares in the companies. The ideology that financial markets were self-regulating allowed illegal gambling free rein. There is no reason under the sun for taxpayers to bail out gamblers
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Wouldn’t creating a clearing house for CDS just turn it into something similar to what equity options have with the OCC? So basically CDS becomes options on fixed income securities.
The big difference is that equity options are standardized, with cookie cutter terms. CDS are tailored to the given client, so they don’t really work on an exchange.
ahahah Wrote: ------------------------------------------------------- > The big difference is that equity options are > standardized, with cookie cutter terms. CDS are > tailored to the given client, so they don’t really > work on an exchange. OK so the most common reason behind not having CDS trade through a clearing house is because they are non-standardized. Well is it possible to set up an exchange that trades the components of the CDS (or any derivative on a corporate bond)? So if I wanted to buy some unique CDS I would go into this markets and assemble that product by buying the different individual risks that constitute that product. I guess market makers could buy and sell small portions of the distinct risk that could be used to build the desired derivative. And the big banks could provide additional liquidity by hedging their own positions by using this framework. Is this at all feasible?
TJR Wrote: ------------------------------------------------------- > ahahah Wrote: > -------------------------------------------------- > ----- > > The big difference is that equity options are > > standardized, with cookie cutter terms. CDS are > > tailored to the given client, so they don’t > really > > work on an exchange. > > > OK so the most common reason behind not having CDS > trade through a clearing house is because they are > non-standardized. Well is it possible to set up > an exchange that trades the components of the CDS > (or any derivative on a corporate bond)? So if I > wanted to buy some unique CDS I would go into this > markets and assemble that product by buying the > different individual risks that constitute that > product. I guess market makers could buy and sell > small portions of the distinct risk that could be > used to build the desired derivative. And the big > banks could provide additional liquidity by > hedging their own positions by using this > framework. > > Is this at all feasible? CME and ICE are already in the process of building the platforms. They are just waiting for regulatory approval. The bigger question is whether a clearing house has the pool of collateral to absorb losses during a market crash and whether it is appropriate to use pooled collateral from futures margins fund those losses. I agree with the above posts - CDS is legalized gambling, as is futures trading. But by requiring all CDS traders to hold the underlying collateral, you create a market with only hedgers - many experts in the derivatives industry say this kills liquidity, which is the lifeblood of price discovery.