Reforming the OTC credit derivatives market

Abstract

The regulatory, operational and market infrastructures environment for OTC credit derivatives, especially credit default swaps (CDSs), is changing rapidly. Although final regulation has not yet been approved, it is nevertheless possible to speculate how the credit derivatives and especially the CDS landscape will look once new regulation is implemented. Priority has been given to more transparency and the establishment of one or more central counterparties clearing houses for CDSs. It has been recognised by the industry that introducing a model similar to that for exchanges might wipe out the added value of OTC credit derivatives, undermining their very existence. Most in the CDS market now accept that central clearing will become common practice. The recent turmoil has forced banks to reassess counterparty risk posed by other dealers. They are now much more receptive for centralised clearing of derivatives.The possibility of one global central clearing house for CDS transactions is limited given the wish of both EU and US authorities to strive for a regional solution. An excessive proliferation of (regional) clearing houses is not to be expected, as that would limit the ability of the central counterparty clearing house (CCP) to reduce financial risks through multilateral netting. CCPs, however, may not be able to handle all types of CDS trades given the much customised, non-standardised nature of them. Because of the global nature of the credit derivatives market, there is an urgent need for international regulatory and supervisory cooperation and coordination, as well as a necessity to create global standards for these markets. In the meantime more than one clearing house in the EU has been set up, but that will ask for interoperability.