Hurry up with that exchange

Credit default swaps remain a large part of this financial crisis, with some analysts crediting the failures in the $58 trillion market as more important than mortgage-related ones. According to IBD, “Counterparty risk was at the heart of the problems that sent Bear Stearns, Lehman and AIG spinning helplessly down the drain. Investors not only worry about their counterparties, but their counterparties counterparties.”

In several weeks, though, CME, formed from the merger of the Chicago Board of Trade and the Chicago Mercantile Exchange, will launch exchange-based trading for credit default swaps. A clearinghouse is also being planned by Clearing Corp., which is owned by 17 financial players including Goldmans and Citigroup and UBS.  According to IBD,

Clearinghouses like those planned by CME Group and the Clearing Corp. address counterparty risks by centralizing the counterparty functions. Instead of a credit protection buyer negotiating individually with the seller, a clearinghouse would act as the counterparty to both buyer and seller. It would guarantee bond payment to the protection buyer. And it would collect payments for the insurance. The clearinghouse also would hold collateral for the contracts and set minimum standards…

Since credit default swaps are now negotiated over-the-counter, standards on such basics as collateral vary widely. “Everyone is different in their requirements,” said Backshall.

And leverage reached outrageous levels. Many counterparties were leveraged 20-30 times, again heightening the risk of default.

The clearinghouses claim they’d tighten collateral rules. In Senate testimony in July, Clearing Corp. pledged to “maintain strict margin collateral requirements.” Donohue said CME’s clearinghouse would require “much higher quality collateral” than what is currently accepted.

But for now the problems keep growing. Standard & Poor’s last week said more than 750 companies risk credit downgrades. Such downgrades would ripple through CDS pricing, increasing turbulence and raising counterparty risk.