Chicago Mercantile Exchange to clear credit default swaps

Posted Mar 18th 2009 4:20PM by Connie Madon
Filed under: Good news, Launches, Personal Finance

The Securities and Exchange Commission granted temporary approval for the Chicago Mercantile Exchange to operate as a Clearinghouse for credit default swaps transactions. Credit default swaps are traded over the counter (OTC), privately, and often secretly.

To better understand the over the counter market, we can look at the way trading is done in the pink sheets. The pink sheets list the bid and ask of more than 6000 stocks. Its an electronic trading platform. The firm also will open an account with a Clearing Firm that has a line of credit.

Credit default swaps are traded in the same way. The market makers are usually big banks who hold a large inventory of credit default swaps. JP Morgan Chase & Co. (NYSE: JPM) for example has an inventory to $87.7 trillion dollars of swaps. Each market maker will need to open an account with the CME and establish a line of credit with them. Now previously, all these trades were not always accounted for, but now each trade must go through the Clearinghouse. The Clearinghouse each day tallies all the trades and then sends each customer a confirmation, similar to the confirmation you receive from a stock trade.

So in essence, what the CME will do is keep track of who's who and provide transparency, which means that there will be a record of all the trades. The Clearinghouse, CME, also monitors the accounts of all the players to be sure that they maintain enough money in the account to cover their trades at all times. If there is a chance of default, the Clearinghouse will immediately determine if the parties have the money to cover all losses.

Do you believe this kind of transparency will work?

Tags: CME clearinghouse for credit default swaps, CmeClearinghouseForCreditDefaultSwaps

Print this

Reader Comments (Page 1 of 1)

3-18-2009 @ 5:03PM

Jason said...

Is that $87.7 trillion dollars or $87.7 billion dollars? I realize that billion is a lot but is it really trillion?

5-30-2009 @ 12:53PM

Lawrence J. Kramer said...

The big problem with CDS contracts is not the opacity of the pricing. The problem is moral hazard. A CDS on a company in which the holder has no significant stake is, in effect, a life insurance contract on that company, unsupported by an insurable interest. The holder _benefits_ from the collapse of the company, and that's always bad public policy.

The law has long prohibited people from taking out life insurance policies on people in whose lives they have no insurable interest. Such a policy gives its buyer a motive for murder and provides no competing social benefit. It is possible to buy existing life insurance contracts on strangers' lives through a "life settlement" transaction, but those arrangements are structured in a way that, as a practical matter, makes murder a poor strategy for buyers. Suffice it to say that the barriers to murder peculiar to the life settlement market are important and they are absent in the analogous CDS setting.

In any event, most naked CDS contracts are issued directly to disinterested buyers, so the life insurance analogy holds. So imagine that John Doe wants to borrow $1,000,000 without collateral from XYZ Bank. The bank examines his credit and says "Ok, you're earning plenty, but you'll need to provide us with a life insurance contract that will pay off your debt to us if you die." Joe, who is in excellent health, easily obtains the contract from CDS Life Insurance Company. Then, unbeknownst to Joe, CDS puts this ad in the newspaper:

----------------
Life Insurance on John Doe

We have recently underwritten the life of John Doe and have found him to be in excellent health (if you ignore his peanut allergy, as we did). To amortize the cost of underwriting Joe's contract, we will be happy to sell an identical contract on Joe's life to anyone who wants one, no questions asked. Joe lives at 10 Maple Lane, Somewhere, USA, and likes to buy his lunch fronm passing vendors.
--------------------

Is that offer any different from what AIG FP proposed with respect to various American corporations? And if not, is there any reason to believe that transparent pricing of this toxic product would do anything to remove the moral hazard it creates?

Naked CDS contracts are a terrible idea, and better price discovery won't make them any less so.