The global financial industry has been abuzz for the better part of the past six months just staying on top of the ever changing developments in industry support and regulatory proposals for Credit Default Swap (CDS) clearing, as well as proposed regulatory reform for OTC Derivatives in general.
The Impacts and Complications – It’s Not Just the Dealers…
The incumbent CDS Dealers that have built and run the CDS markets must quickly ramp-up their infrastructure to support CDS Clearing in the US and EU. Here is a brief list of the complications they currently face, with an emphasis on technology & operations:
• Each Central Clearing Counterparty (CCP) has subtle or dramatic differences in legal and operational requirements to participate as a Clearing Member, adding to the complexity of the following points
• Post-trade processing, particularly margining & reconciliation for cleared CDS products will behave more like listed derivatives, so existing OTC technology & operations will need to get up to speed quickly on the “lingo” of the cleared world
• Listed derivatives infrastructure may not be fully “CDS-aware”, particularly to the idiosyncrasies of the CDS trade lifecycle, including the response to credit events, etc…
• Impacts on Credit Risk, Economic & Regulatory Capital must be assessed and planned for, particularly with the heightened sensitivity to these topics given the current market
• OTC & Listed Derivatives businesses may very well fall into separate Legal Entities, which make the Accounting, Legal and Compliance changes required even more challenging to conquer in the short timeline
• Prime Brokerage support for cleared products, particularly as they relate to existing product offerings in the Prime space must be tackled as well, in order to stay competitive as more Prime clients take an interest in the cleared CDS markets
On The Buy-Side – Hedge Fund Managers & Fund Administrators
A number of hedge funds are already very active participants in the bi-lateral CDS market, “giving up” their trades to their Prime Brokers and eliminating the need for a lot of post-trade infrastructure. Dramatic reduction in counterparty risk via the CCP model and improved operational efficiency and liquidity in the standardized CDS products will likely drive more hedge fund managers to participate in this market. The impact in this case is pretty straightforward: more participants on the buy-side will need additional infrastructure to trade cleared CDS and manage portfolios that contain CDS.
Over the past month there have been a number of announcements and legal recommendations to permit direct buy-side participation in the CCPs. The question remains as to what this means from a market structure standpoint, particularly to Prime Brokers. If the buy-side does have direct access, it will likely require additional post-trade infrastructure to deal with the CCP operational requirements, including margining, cash movements, etc…. Changes to existing collateral management processes and systems may be a suitable alternative path as well, especially given the recent trend to invest in this infrastructure.
For Fund Administrators and Fund Managers alike, the accounting treatment for cleared CDS will likely require additional journal entries to account for margin movements, etc… which will likely require additional portfolio accounting support and/or liquidity management changes.
On the Buy-Side – Asset Managers
More traditional Asset Managers, particularly those who have dabbled in or want to take more of a position in CDS to enhance their returns may now be able to do so because of the lack of counterparty risk in the products. These shops will likely require additional technology & operations support, similar to what hedge fund managers may require, but with a clear eye toward direct participation in the clearing markets without a Prime Broker as intermediary.
The Critical Question
As the CDS Clearing story continues to evolve, now is the time to start the discussion. What do you need to do to prepare for CDS Clearing? Share your thoughts below along with any examples others may find useful.