Within the next few weeks four clearinghouses for credit default swaps may open for business. U.S. regulators have been pushing for one or more central counterparties to bring transparency to the famously opaque credit default swap market. A clearinghouse from NYSE Euronext Inc. has already received the go-ahead from regulators, and at press time, three clearing facilities from CME Group Inc. and Citadel Investment Group LLC, Intercontinental Exchange Inc. and a consortium of CDS dealers, and Eurex Clearing AG were awaiting final approval. Still, that doesn't mean that a significant number of over-the-counter derivatives will necessarily begin clearing anytime soon. So says Robert Claassen, chair of the derivatives and structured products group at Paul, Hastings, Janofsky & Walker LLP in New York. We talked with Claassen to find out why.
Movers: You say that some CDS contracts are simply too complex to be cleared. Can you explain?Robert Claassen: A large portion of the CDS market is fairly standardized. That would be things like buyers buying protection against particular mortgage-backed securities or particular indices or sovereign debt. Things like that could very well be cleared. The challenge will be in the more complex instruments. We do CDSs on CDSs; we do CDSs on bonds; we do CDSs on stocks; we do them on loans. You can do CDSs on anything. I just can't imagine the clearinghouse is going to be able to contemplate the variety of potential CDS transactions. Frankly, I don't think it would be economical.
If some of the most complex transactions can't be cleared, does that undermine the ability of a clearing facility to help avert the type of systemic market breakdown we saw in 2008?
I don't know that it undermines the idea of it. I think a clearinghouse will be great for a large portion of the market. One of the things that prompted this financial crisis was when people started to raise questions about the credit of the monoline insurers and of the validity and safety of the CDSs they had underwritten. All of a sudden, the underlying assets the brokers had taken with that protection had to be written down. Had those monoline insurers not lost their credit standing, I think a lot of this stuff wouldn't have happened, because the clearinghouse is triple-A-rated, so they wouldn't have had the credit problems.
What's your take on ideas being bandied about in Washington to regulate the CDS market?
There is concern over some of the things being said, like, "We want all CDSs traded on exchanges. We want that mandatory. We don't want the OTC derivatives market." All sorts of people are very vehement in that view. I think that's generally people who have never seen a CDS contract or negotiated one or purchased one.
What options do lawmakers have?They have two choices. Either they can come up with an exemption for noncustomizable OTC transactions, or they can say, "No, we have no exemption," which I think is where [Sen. Tom] Harkin is headed. If that happens, I think the market will move offshore. I suspect, though, that once Washington really digs into this and starts understanding the complexity a little bit more, I think [lawmakers will] come to the right decision. Which is, let's encourage an exchange, let's try to get what we can onto an exchange, but let's not destroy the rest of the market. Regulation, though, is going to be key. And I bet you're not going to see a lot of trading on the clearinghouses unless and until Congress really acts.