In a new paper, I discuss whether mandatory central clearing of single-name credit default swaps (CDS) should be adopted in the United States and Europe — an issue with important consequences for financial stability in both regions.
CDS are financial derivatives between two counterparties that “swap” or transfer the risk of default of a borrowing reference entity (a corporation, bank, or sovereign entity). The buyer of the CDS, also called the protection buyer, needs to make a series of payments to the protection seller until the maturity date of the financial instrument, while the seller of the CDS is contractually held to pay the buyer compensation in the event of, for example, a debt default of the reference entity. Single-name CDS are mostly traded in the over-the-counter derivatives markets, typically on confidential, decentralized systems, and had a total global value of around $4 trillion in 2023.
The terms of the derivatives contract are negotiated between the two counterparties and, therefore, tailored to their preferences, but the vast majority of CDS trades use the definition of credit events developed by the International Swaps and Derivative Association (ISDA). Note, however, that the ISDA Master Agreement is not mandatory and may be altered by the counterparties.
Why Is the Question of Centrally Clearing CDS Relevant Again?
In March 2023, three small-to-mid-sized U.S. banks — Silicon Valley Bank, Silvergate Bank, and Signature Bank — ran into financial difficulties that spilled over to Europe, where Credit Suisse needed to be taken over by USB. Holders of the $17 billion of Credit Suisse bonds were not part of the rescue deal, and investors were left empty-handed, adding to the fear of negative consequences for other European banks. During that turmoil, the value of EU banks’ CDS rose considerably. For instance, Deutsche Bank’s CDS price rose from 55 basis points on March 8 to 250 basis points on March 24. For Deutsche Bank, there were even more than 270 CDS transactions for a total of $1.1 billion in the week following UBS’s takeover of Credit Suisse. This represented a more than four-fold increase in trade count and a doubling in notional value compared with average volumes of the first 10 weeks of the year.
The CDS market is typically illiquid, with only a few transactions a day for a particular reference entity, so this increase in trading volumes was exceptional. On March 28, 2023, the press reported that regulators had identified that a single CDS transaction referencing Deutsche Bank’s debt of roughly 5 million EUR conducted on March 23 could have fueled the dramatic sell-off of equity on March 24, causing Deutsche Bank’s share price to drop by more than 14 percent. Hence, an illiquid market with relatively small deals could have exerted a heavy impact on share prices.
After the turmoil in March 2023, Andrea Enria – chair of the supervisor board of the European Central Bank – argued that central clearing for CDSs would improve post-trade transparency and reduce the risk of volatility. This highlights the question of whether mandatory clearing could have prevented the problems of March 2023. Single-name CDS contracts can be cleared voluntarily at, for example, the French CCP LCH.Clearnet SA or at the U.S. CCP ICE Clear Credit LLC, but 75 percent of client gross exposure in the single-name market remained uncleared at the end of December 2020. Yet clearing is not yet mandatory in the U.S. and Europe because the market has not been deemed sufficiently liquid by the European Securities Market Authority (ESMA), and the SEC does not require clearing for single-name CDSs either.
The Benefits and Drawbacks of Centrally Clearing CDS
By acting as an intermediary between buyers and sellers, central counterparties (CCPs) help to mitigate counterparty risk. In addition, multilateral netting of exposures is made possible by the novation of bilateral contracts (i.e. the central counterparty becomes the buyer toward the seller and the seller towards the buyer) by the central counterparty. Because of central counterparties’ multilateral netting activity, the number and value of outstanding settlements (i.e. asset deliveries and accompanying payments) between different parties decline, lowering the market’s overall credit exposure and also the amount of collateral needed. By minimizing the potential impact of a single participant’s default, central clearing contributes to overall financial stability. CCPs mitigate the impact of a market participant’s possible bankruptcy by pooling credit risk. Furthermore, because central clearing requires more margin than bilateral clearing and leads to more transparency, it prevents counterparties from taking on excessive risks.
Yet, there are also numerous arguments for why the single-name CDS market is not suitable for central clearing and why central clearing would have disadvantages for CCPs and market participants. A clearing mandate for single-name CDSs could increase systemic risk by importing exposures into the CCPs, which might be difficult to manage in a stressed environment. The cost of using a central counterparty can also be expensive from a margining perspective compared with many firms’ bilateral collateral exchanges. Furthermore, the introduction of clearing fees may increase bid-ask spreads and decrease trading volumes. That is, clearing fees decrease the profits of dealers for providing liquidity, and they may therefore increase bid-ask spreads to remain constant in profits per trade. The high margin requirements could even prevent certain smaller market participants from having access to clearinghouses as not all investors can afford to set aside a non-negligible amount of capital as a contribution to a default fund. In addition, dealers could respond to higher-order-processing costs due to increased margins by widening bid-ask spreads, which would reduce the attractiveness of the CDS market for end-users.
Another risk of central clearing is that, although ISDA Master Agreements are often used, many CDS are not standardized, because buy-side firms tailor their contracts to their specific hedging needs, thereby reducing their fungibility. The absence of standardization leads to the absence of reliable and tradable prices that are necessary for a CCP to calculate the daily mark-to-market requirements. That is, for a CCP to determine its margins, capital reserves, fee standards, or default fund contributions, the contracts will require highly standardized terms to allow pricing and the assessment of total risk. CCPs need to perform a valuation of the instruments they clear to calculate the margin requirements or applicable haircuts and also need to make sure that they can be liquidated in case of a clearing member default. In the case of illiquid instruments, such as CDSs, this process is difficult.
Conclusion
Although mandatory clearing would have many benefits, such as fewer counterparty risks and more transparency, most single-name CDS are too illiquid, not sufficiently standardized, 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. Hence, legislators are advised to thoroughly examine all the pros and cons before making a final decision about this complex debate.
This post comes to us from Randy Priem, a professor at the UBI Business School of Middlesex University London and Antwerp Management School at the University of Antwerp and a coordinator of the markets and post-trading unit at the Belgian Financial Services and Markets Authority (FSMA). It is based on his recent paper,“Single-Name Credit Default Swaps: To Clear or Not to Clear?” available here. The views expressed in this post are the author’s and do not necessarily represent those of the organizations with which he is affiliated and do not bind the FSMA in any matter.