Someone on Capitol Hill has been reading The Ticker. A draft bill is circulating in Congress to bar trading in CDS contracts that are not covered by an underlying. Needless to say the financial industry is already howling about it, but the reason for the complaint is simple - they don't want price transparency!
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.
Ding ding ding ding!
See, today if I call a prime broker (say, Goldman) and ask for a quote on a CDS for Frobozz Company, they can quote me literally anything. They might be able to buy that contract on the market at 400 basis points, but they then quote me 500. Is that a fair price? I don't know. Maybe, maybe not - but the fact that I can't sit in front of my computer and see all the bids and offers in the market like I can with a stock, option, or futures contract allows the dealers to game the market and screw the customer with impunity. The dealers love this, but one of the hallmarks of an efficient market is that pricing information must be made available to all market participants equally.
The other thing that happens with exchange-traded markets is that the clearinghouse becomes the intermediary - that is, they are the seller to every buyer and the buyer to every seller, effectively guaranteeing performance. That in turn leads them to impose strict margin supervision on the firms doing business through them, because if they fail to do so they are on the hook when counterparties cannot pay. As a consequence centralized clearing instantaneously removes the "systemic risk" that CDS currently pose to the financial system as a whole since nobody in their right mind is going to permit firms to run without proper margin supervision under such a paradigm.
The other howl - that its "unfair" to prohibit naked CDS - is silly. There are already ways to place wagers in the marketplace on a firm's solvency if one is inclined to do so. There are single-stock futures contracts for some names and there are options contracts available for most others. A firm that defaults on its debt will see its equity trade for pennies - if you truly wish to speculate on that, the options marketplace seems to be the perfect spot for it, as it is already regulated, bid, offer and open interest are already displayed, and margin maintenance is already enforced against contract writers.
As a matter of principle I have no issue with "naked" CDS writing provided that the same regulation is enforced in that marketplace as there is in the listed options market. If market participants believe that there is a need for a credit-specific speculative tool much as there is an equity-specific speculative tool (as distinct pieces in a firm's capital structure) then so be it - provided that it is regulated and supervised as is the case on the equity side.
The same issue exists for interest-rate swaps. This has become a horrifyingly fraud-ridden area with municipalities over the last few years, with several horror stories coming to light already and many more, I'm sure, "in the pipeline." Again, these are tremendously lucrative for the banks in no small part because there is zero transparency in pricing and open interest, leading to all sorts of fun games in which the issuing bank has an embedded profit that by any reasonable measure can only be called obscene and the buyers have literally no way to keep from being ripped off. While hedging interest-rate risk is a legitimate need, again, the lack of central listing and settlement of these contracts puts buyers at a severe disadvantage compared to the dealers that are pushing them, and once again, chicanery of various sorts and even outright fraud has run riot over the last few years.
While the proposed bill is not perfect, it's a good start. Let's hope that Congress will take this up, polish it up so that the pricing inequities and supervision requirements necessary for an efficient, transparent and safe marketplace are met, and enact it as law.
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