The other issue with this, is these did not trade on an exchange like a stock - basically it is private party transactions - which can set up many abuses if you want to create an air of fear about a stock. Whose to say 2 hedge funds are not trading with each other and bidding the CDS up higher and higher - which creates an infinite upside. In theory the "seller" of the contract should have the money set aside to pay it off if in fact they are called to do it, but without any regulation in place - who is to know if any money is set apart. In fact, we know it has not been since AIG appears to be on the hook for a ton of these contracts and they obviously did not set aside enough - or else the Federal Reserve would not be offering them a lifeline (in case you missed it, on top of the original $85 Billion loan, AIG this week went and got another loan from the Federal Reserve ; this one for $38 Billion) So you have insurers who can be "anyone" (private party) who no one is watching to see if they even have the cash to pay off in case the insurance "comes do" - and these contracts are deemed by the market as a "signal" of the leath of a company's debt. It is all a big mess and can be gamed to such a degree - but hey 'free markets should not be regulated' ;)
Anyhow, this is a huge market and these seem to be the 2 favorites for the future exchange(s) - in fact CME Group announced this week plans for a market with giant hedge fund Citadel. I think the key here is Citadel which is dominant in quite frankly anything they touch.
- CME Group Inc (CME) and Citadel Investment Group unveiled plans on Tuesday for an electronic exchange for credit default swaps, the securities blamed for the unraveling of several Wall Street firms, amid growing calls by regulators to move the $55 trillion CDS private market to exchanges.
- CME, the world's largest derivatives exchange, and Citadel, a big hedge fund, said the new platform should be launched within 30 days. It will be integrated with a central clearinghouse, which would guarantee the contracts that were at the epicenter of the financial meltdown.
- Proponents argue that exchange trading would remove the systemic risk posed by a counterparty failure, make prices transparent and offer simpler, more standardized settlement of contracts when an issuer defaults. "Everybody is afraid to trade with everybody because they don't know who will be left standing, and a central counterparty system is going to help dramatically improve confidence."
- Despite the plan, CME and Citadel may face an uphill battle in convincing dealers to provide the exchange with the liquidity it will require to be successful. Dealers have been hesitant to support exchange trading in the past as the private market is more profitable. CME Group and Citadel are offering equity stakes in the joint venture to major market participants to encourage support for trading on the exchange. Donohue told Reuters he hopes the remaining 30 percent stake will attract market participants, who in turn will bring their book of CDS exposures to the new clearing house.
- Still, Citadel has a good track record in competing against dealers, he added. "Citadel has demonstrated its strength to compete against dealers when it captured 20 percent share in Treasuries, an OTC market previously controlled entirely by the 'club' of dealers," Perfumo said. "Citadel may do it again in CDS."
Here is an interview with CME CEO from Fast Money, on CNBC
In breaking news, the Wall Street Journal reports that the NY Federal Reserve this week will summon all participants in the market for bond insurance. That includes credit default swaps.
Finally, we might be getting a real solution to the issues generated by credit default swaps. Only one day ago CME and Citadel said they are inking a deal to create a platform for trading credit default swaps.
And for the first time since the deal, CME CEO Craig Donohue speaks out about how he plans to restore confidence on Wall Street.
“We’ve been working with the regulatory community to layout what we can do at the CME group,” reveals Donohue.
Currently credit default swaps are traded privately with their opaque nature believed to be at the heart of the Wall Street crisis. Putting them on an exchange, such as the Chicago Mercantile Exchange, should add transparency if only because investors will be able to see how much others are willing to bid.Despite the plan, CME and Citadel may face an uphill struggle. Dealers have been hesitant to support exchange trading in the past because they typically generate more profit from the private nature of the market. “I have to be honest and tell you that we’ve been trying to offer central counter-party clearing services to over-the-counter market for a couple years,” Donohue adds.
To date CME’s attempts to become the clearinghouse for these securities have not been successful. But, maybe times are changing.
