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Japan's CCP connundrum Monday, March 14, 2011

Derivatives Week 14th March 2011 edition is reporting that Japan's Regulators are seeking to provide clearing members with limited liability at the same time as preserving the local law which precludes a CCP from going bust.

The reported solution for who should pick up losses in the event of a default exhausting the resources of the CCP, which includes capped contributions of surviving members, is to declear trades back to their original counterparties.

This is an awful solution, widely rejected in almost all major CCPs, for several reasons.

Firstly, it removes certainty from clearing. As a consequence, counterparties will retain a contingent exposure to their original counterparty, with a consequential capital requirement.

Secondly, in most CCPs, trades are offset with each other to create net positions with the CCP. Under this model, one clearly cannot net trades since preserving the identity of the original counterparty is essential if trades are to ever be re-allocated back. As a result, whilst one may have exited a position some months/years ago, a potential exposure remains if those trades are ever unwound by the CCP to revert back to a bilateral exposure. To close such an exposure in the ordinary course of business, one may have to do offsetting trades with the original counterparty, but even that may not suffice depending upon how the CCP determination of unallocated trades works.

Whilst members cannot be exposed to an unlimited liability in order to keep a CCP afloat, and the possibility of a CCP failure sends terror into the heart of regulators, operating contingent clearing simply creates other unpalatable problems.

I sincerely hope that the groups working on this will come up with a more palatable solution, hamstrung as they are by the notion that a CCP may not go bust.

Labels: auction, CCP, CDS, Credit default swap, Japan, member default

posted by John Wilson @ 10:05 AM Permanent Link ,

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CDS losses are going to sink some funds Monday, October 06, 2008

With a number of financial institutions going under, receiving state aid or being nationalised, large payouts under credit default swaps ("CDS") are looming since these constitute credit events under any normal contract.

Payouts under CDS contracts are typically determined via an auction for the debt - the deficit between the auction price and par being the payout. This week defaulted credit derivatives linked to Fannie Mae and Freddie Mac were settled at 92 to 93 cents in the dollar. With up to $500bn of credit derivatives linked to them, this could mean pay-outs of $35-40bn by sellers of default protection.

Due to the OTC nature of CDS deals, the identity of the end holders of these losses i.e. the "insurers", are not a matter of public record. Hence, worries abound regarding who will have to absorb these losses and their ability to settle the claims. These concerns are further fuelling the panic in the markets since it could result in further collapses. Hedge funds, insurers and banks are all potential "victims".