Mandatory central clearing for CDSs “not the holy grail solution”

The bank failures of 2023 threw single-name credit default swaps (CDSs) into the limelight. Regulators are now contemplating mandatory clearing for these derivatives, even while a debate about the validity of such a measure rages on. In an opinion piece for Promarket, a publication by The University of Chicago Booth School of Business, finance professor Randy Priem discusses why central clearing might not be the answer in this segment of the market.

A different risk

In theory, central clearing should reduce risk, but in practice, it might backfire and lead to a contrary result. A clearing mandate for single-name CDSs could “increase systemic risk by importing exposures into the CCPs”, Priem points out, which could be “difficult to manage in a stressed environment”.

A lack of standards

The contract drawn up between the counterparites in a CDS trade is usually based on a master agreement developed by the International Swaps and Derivatives Association (ISDA). The use of the master agreement is voluntary and its terms can be altered to suit the needs of the counterparties.

This lack of standardisation creates a roadblock for central clearing. “For a CCP to determine, for example, its margins, capital reserves, fee standards, and default fund contributions, the contracts will require highly standardised terms, not only in terms of pricing but also to assess the total risk,” Priem writes. CCPs have to ensure they can also be liquidated if one of their clearing members defaults, but “In the case of illiquid instruments, such as CDSs, this process is difficult”.  

The money issue

Central clearing means higher margin requirements. Priem predicts that this might make access to clearinghouses more challenging for smaller market participants. “Not all investors can afford to set aside a non-negligible amount of capital as a contribution to a default fund.”

In addition, higher order processing costs due to increased margin requirements and the introduction of clearing fees may eat into the profits of dealers. To keep the same profit per trade, they are likely to increase bid-ask spreads. This will reduce the attractiveness of CDSs for end-users, therefore reducing trading volumes.

To conclude, Priem argues that “most single-name CDSs are too illiquid, not sufficiently standardised, and too opaque to be suitable for mandatory central clearing, at least in the short term. They would lead to a considerable prudential risk to CCPs without the latter being able to provide many multilateral netting benefits.”