Streetwise Professor

December 10, 2008

Some Things Just Don’t Mix

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 11:00 pm

There are two competing models in CDS clearing.   The CME model is to clear these products through its existing clearing structure, effectively “co-mingling” futures risks and CDS risks.   The alternative model, embraced by ICE and Eurex, will clear CDS and futures products seperately.

As I’ve mentioned on a few occasions, there is considerable tension among CME clearing members over the co-mingling idea.   This article from DJ News Wires details the competing claims and complaints over the various models:

CME argues that “co-mingling” futures and CDS contracts in its clearinghouse will avoid an additional capital call on banks and dealers.

The strategy has generated warnings from some of CME’s largest partners in the futures industry, who are concerned they will be exposed to CDS risk.

Patrice Blanc, chief executive of Paris-based Newedge, said co-mingling futures and CDS clearing is “dangerous,” and that it could “create huge systemic risk” for market participants.

Clearing CDS contracts is “a much more complex issue than it’s been made out to be,” Blanc said in a recent interview with Dow Jones Newswires.

Thomas Peterffy, CEO of electronic brokerage firm and CME clearing member Interactive Brokers, has also come out against mixing futures and CDS risk on CME’s platform.

Co-mingling of futures and CDS risk could threaten the integrity of a clearinghouse, says Roger Liddell, CEO of London-based clearinghouse LCH.Clearnet.

He also cautioned that clearing CDS trades may be more complicated than many believe.

“There is a risk in assuming that everyone can clear everything,” Liddell said at the Futures Industry Association’s 2008 Expo in Chicago last week.

I concur with the various cautions voiced by Liddell, Blanc, and Peterffy.   They are, in effect, in agreement with my assessment that CDS clearing presents acute balance sheet and product risks that are inherently more costly to share through a clearinghouse, due to asymmetric information problems.

Now, “co-mingling” is synonym for “diversification.”   In a world of complete information, the CME’s Kim Taylor would be exactly right:

Kim Taylor, president of the CME clearinghouse, has acknowledged the concerns. She argues that combining the risk of futures and CDS contracts in one clearinghouse provides diversification, lower overall risk and cutting trading costs.

Taylor, speaking on a panel at the FIA event, noted that risk management for the clearinghouse as a whole has become more efficient when CME has brought new product lines into its clearinghouse, notably the energy and metals contracts from the New York Mercantile Exchange.

In a world of complete information, with no information asymmetry, there are economies of scope in clearing.   Through the diversification effect, the riskiness of a combined CDS and futures portfolio would be lower than the sum of the risk of the stand alone CDS portfolio and the risk of the stand alone futures portfolio.   Moreover, clearing across products economizes on margins.   Again, due to the diversification effect, with a combined portfolio one can achieve the same default loss profile for a smaller margin than one can with seperate portfolios.

So, co-mingling sounds like a no brainer.   So why aren’t savvy market participants buying this?   I think the answer is pretty clear.   They understand that this is not a situation of complete information.   Due to information problems, moral hazard and adverse selection problems make it costly to clear CDS trades.   CME clearing members are quite right to be very leery of importing the product and balance sheet risks associated with credit default swaps into a futures clearing system that has worked very well.

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