CDS back office still a looming nightmare?

Mon, 28 Apr 2008 06:59:59 -0400

It's hard to believe that the credit default swap (CDS) market is now about twice the size of the U.S. stock market. But it's true. The market has been growing phenomenally and, despite a lot of nervousness over the past year, it looks like it is here to stay, though growth might moderate.

All that said, it is a very immature market, and if a wave of defaults ever hits, or if bond insurer (they are huge players in this market) anxiety soars, the market could well stop functioning. The fact is, the market's clearing and settlement processes are roughly akin to the 1960s methods of settling stock trades. Recall the classic John Brooks book, The Go-GO Years, which revealed the Wall Street back office as a purgatory of paper and stoned processors. It's shocking in this era of rampant technological progress that top banks are settling trades with faxes and spreadsheets. The Fed has been onto this problem for some time, and progress is being made.

But one could argue that now is the time for a Wall Street equivalent of a Manhattan Project, and before it's too late. Some believe that the market, despite its low-tech foundation, has withstood the worst. Others think that the worst is yet to come. I say, why wait around? The issue needs to be put back on the front burner. We're looking at some thorny issues that directly effect valuations and earnings if back office shuts down, which is more than conceivable in a market panic.

So technology and automation is the answer. But somehow, it has to be made a priority. Resources will be necessary and frankly, it strikes me as an area that a start-up might want to tackle, creating an ECN sort of system. In any case, someone's got to do something. - Jim

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