April 17, 2015
The purpose of the Dodd-Frank requirement for clearing CDS obligations through a clearing house was to provide increased transparency and stability to the financial system, in view of the extensive use of CDS issuances to limit risk associated with very high volume asset transactions. The clearing house was to provide assurance of the counter-party, and financial assurance of settlement of risks associated with transactions, by monitoring the credit and financial stability of CDS market participants.
Now, the proposed rule would modify the role of the clearing house to provide a guarantee of physical clearing under extreme circumstances. While this may be feasible, and potentially desirable, it introduces an additional complexity into the system which might only be tested during periods of financial stress, ie when an auction method could not or would not determine the value of the CDS obligation for financial clearing. Under these circumstances, it would be prudent ot address three issues with respect to this proposal. First, the process, financial assets and liabilities, and legal obligations of all parties must be well understood. A claim that something had to be physically cleared involves both parties to a CDS obligation as well as the clearing house. Ambiguity or uncertainty about the process, notice, and payments involved would be a legal morass, although a bonanza for lawyers. The SEC must be satisfied that the process, notice, timeline and execution steps for physical clearing are well specified, as well as the obligations of all parties, and a method for dispute resolution. As a second issue, the financial stability of the clearing house is now interposed among market participants, and therefore the SEC should have some periodic report on the clearing houses financial assets, potential obligations or value at risk, and ability to perform under normal or adverse circumstances. A periodic risk assessment, perhaps annually of clearing house risk and stability to perform physical guarantees should be provided. Finally, the SEc should be aware, and undertake assessment of the impact of any such guarantee of physical clearing on market participants, that is CDS issues and buyers, to determine whether the clearing house role is having any impact of reducing their own financial commitment or increasing leverage as the result of the clearing house physical clearing guarantee. These are complex issues, and the implications of this change should be assessed, periodically review, and well understood by the Commission, CDS market participants, and the public.
The attached files demonstrate the multiple moving pieces which must be understood in connection with this issue
Copyrighted material redacted. Author cites:
Goldman Sachs Asset Management. "The Dodd-Frank Wall Street Reform & Consumer Protection Act sets out that certain derivatives contracts must be cleared through a Central Clearinghouse (CCP)" , 2012.
Yang, Qiao, and Si, Shen. "Credit Derivatives: CDS, CDO and financial crisis", 2010.