CDS market solutions ramping up

Finally, after a long stretch of hand wringing about credit default swap trade processing, it seems like we're about to get some real progress. There are several exchanges and other entities in the hunt to create some sort of clearing solution, and the chances are now good that at least one will be up and running this year, perhaps as early as this month. 

This certainly reflects the regulatory climate; officials have been pushing the industry hard in this direction, but the details are tricky. You still have to think that ultimately, widespread adoption--barring drastic regulatory action--will be determined by the dealers. 

While pure exchange solutions have existed in the past, the dealer community has never warmed to them. This is understandable. It would be fair to say that moving the market to a traditional exchange might eventually push the market down the same path that equities, options and, to a lesser extent, bond markets have traversed. You could imagine the exchange pushing for narrower spreads (decimalization?) and other order-handling-like rules that would ultimately crimp dealer profits. 

CreditSights, which does a solid job keeping up with these tricky issues, suggests the lack of dealer support may undercut the much-publicized CME-Citadel proposal. It has been praised as a viable solution technologically, but is it dealer-friendly enough? For one thing, it might allow non dealers, like funds and corporate hedgers, to "face" the exchange and initiate trades--which might be seen by some dealers as opening a path to disintermediation. Importantly, it might also entail margin and lending requirements, which dealers set themselves now. Recall that lending in this area, until the crunch, was a huge source of profits for the big dealers. Perhaps not so anymore.

Given these issues, the non-exchange clearinghouse proposed by the ICE/Clearing Corp. starts to look even better. It offers a lot, not least of which is list of key partners like Markit. It will also act as a limited purpose bank and therefore be subject to Fed regulation. Importantly, dealers will "face" the clearing entity when it makes trades, which would solve the counterparty risk problem. Originally, it was assumed that nonmembers would not be able to "face" the clearinghouse, meaning they would have to trade via dealers. But as of late, that issue has been obscured, and as of right now, it is not clear at all.

All in all, dealers may not be the ones you want crafting the best possible solution. They're interested, as they should be, in preserving margins. Still, given the pressure, we're going to get some sort of solution fairly soon. As CreditSights notes, we may end up with more than one, which might not be a bad thing. - Jim