TORONTO -- The movement of credit-default and other forms of complex financial swaps into electronically managed and centrally cleared markets may be increasing rather than lowering risk, Michael Bodson, chief operating officer of Depository Trust and Clearing Corporation said Tuesday at SIBOS 2011 here.
Credit-default swaps are “scary, scary products,” Bodson said in a discussion of the transaction infrastructure that is emerging after the 2008 global credit crisis. The exchange of risks involved in these swaps may not fit well on a transaction model that has been used for futures contracts, which are simpler forms of derivative securities.
Plus, he said, the credit-default swap market is about ten times the size of the futures market, which gives a sense of the risks involved. The European Union has estimated the size of the CDS market at $28 trillion, out of an over-the-counter, bilaterally negotiated derivatives market of $600 trillion.
“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.
He noted, for instance, that a central counterparty failed during the Asian financial crisis of the ‘90s.
The DTCC has been working on developing means of Standardized Data Reporting (SDR) that will help fund firms, trading firms, regulators and other market participants better manage growing volumes of transactions by identifying parties involved better.
So far, he said, the new swaps markets are only ready to clear about 400 names. But DTCC’s SDR includes 4,000 names that have been involved in such swaps.
Lawrence Sweet, senior vice president, Federal Reserve Bank of New York, said the risks can be reduced by processes such as multilateral netting of transactions and centralized collateral management.
Risk management procedures must be strong and the new systems “sufficiently robust” to guard against failure of central counterparties or firms involved in the trades.
And, he said, those swap contracts that are too complicated or risky to be put into centrally cleared, electronic markets should not be. The question is “how much can we put in there in a safe way,’’ he said.
Clearing and settlement worked well, even in the midst of the crisis, he and Werner Steinmueller, managing director, head of global transaction banking and a member of the Group Executive Committee at Deutsche Bank, noted. And, Steinmueller said, the industry and regulators should “not change systems that were extremely stable.’’
Particularly stable, he noted, were systems for handling payments cash equities, aka, stocks.
Fifteen years ago, he noted, market participants set out to reduce settlement risk in foreign exchange transactions. Multiple initiatives emerged around the globe, he said, before a final, single system got widespread backing.
Now, $4 trillion, $5 trillion or $6 trillion worth of exchanges get settled safely, daily.
“When the issue is compelling, a clear vision and people are working toward it, it can be done,’’ he said.
Which is where central clearing of swaps first came in. The global credit crisis, Bodson said, “was a mortgage-backed crisis with CDS wrappers.’’
-- This article first appeared on Securities Technology Monitor.