I discussed credit derivatives previously here.
One of the world's fastest-growing markets calls in the plumbers
OVER a year ago, a whiff of something nasty filled the nostrils of the world's financial regulators. It came, appropriately, from the back end of the credit-derivatives market, an unregulated asset class that was growing so fast that banks and hedge funds that dabbled in it had lost track of their trades.
In other markets where trading is private (rather than on an exchange), the problem might have seemed minor, involving thankless back-office tasks with monotonous names like matching and confirmation. But this time regulators saw a threat to the stability of banks, because of the popularity of credit-default swaps (CDSs), instruments that disperse lending risk around the financial system.
From almost nothing in 2000, trading in CDSs has ballooned to a notional value of $17 trillion at the latest count. That still leaves plenty of room to grow—interest-rate swaps, for example, are a $160 trillion market. But the CDS market, which allows banks and other financial firms to buy and sell protection against the risk of default by a borrower, punches above its weight. According to the International Monetary Fund, it is far bigger than the world's corporate-bond markets, it helps set the cost of borrowing by companies, and it might even reduce swings in the credit cycle.
For all its virtues, however, its practitioners have been hopeless at keeping tabs on their own trades, especially in the secondary market into which hedge funds have stormed. So last year regulators pressed the industry's 14 top dealers, which they do supervise, to put their rubber gloves on and sort out the plumbing.
Since then, bankers in a group known, like a ruling clique, as the “14 families” have laboured to Dyno-Rod a backlog of unconfirmed swap trades. Prodded by regulators, traders have shut themselves in hotel rooms for one weekend after another to sort out discrepancies with their counterparties. Some banks have even temporarily halted trading to allow the back offices to catch up with the sales staff.
The efforts appear to have borne fruit. The main dealers agreed to a June 30th deadline to cut the backlog of unconfirmed trades by 70% from their levels when they were first summoned by the Federal Reserve Bank of New York last September. “Everyone's already achieved that, as far as I know,” said Mark Davies, head of global credit trading at Bear Stearns, one of the firms.
Yet the smell has not quite gone away. Last month Alan Greenspan, former chairman of the Federal Reserve, startled bond traders at a dinner in New York with both a friendly pat and a slap on the wrist. Credit derivatives, he gushed, were “becoming the most important instruments I've seen in decades.” But he then went on to say how appalled he was at the “19th-century technology” used to trade credit-default swaps, with deals done over the phone and on scraps of paper. In London the Financial Services Authority, which has warned that unconfirmed trades could cause liquidity problems and accelerate a financial crisis, is partially mollified. “We've gone from a red light to an amber,” an official says.
It goes without saying that an automated, transparent back-office system is a good way to bring new investors into the market and improve liquidity. There is also broad support for the way regulators have let banks find their own answers to the problems, rather than imposing rules.
But the supervisory oversight, as well as the solutions dreamt up by the big dealers, make some people nervous. They think there may be subtle changes in the $220 trillion market for over-the-counter derivatives, which is unregulated because it involves trades between private parties.
A good deal of the grumbling comes from hedge funds. Some of these, bankers say, have unsuccessfully resisted moves to automated trading, preferring to keep details of their trades to themselves and to play dealers off against each other.
There are other worries. At the centre of the complex trading infrastructure is a vast industry-owned utility called the Depository Trust & Clearing Corporation (DTCC), which the 14 dealers—ten of which have seats on its board—see as integral to automation (handily, it gave such users a rebate of $528m last year). The utility seeks to stitch together electronic platforms that stretch from traders' desks, through confirmation, to storing records of derivative contracts until they expire.
DTCC's prevalence has led to concerns that putting so much global information into storage in America may one day make the industry subject to American regulation, no matter where trades take place. The utility's Peter Axilrod believes this fear is unwarranted. He points to the light touch shown by supervisors so far.
Another fear is that DTCC might trample on private competitors as it moves into other areas of derivatives. When it began testing a system for recording initial agreements to trade last month, it described itself as a tap-dancing gorilla.
Such concerns are likely to loom larger now that the backlog of paperwork has been reduced. Of particular interest is whether DTCC will realise its ambitions to store hundreds of trillions of dollars' worth of credit, equity and interest-rate derivative contracts. This would be a hugely complex task: already it admits that its plans to warehouse CDS contracts are taking longer than expected. And the rest of the world might well worry that too much of the plumbing of a global market would be on American soil.