Intelligent CDS Reform

The WSJ has a great article today suggesting the benefits of a central clearinghouse for derivatives contracts that are currently traded over the counter.

Here is the article: Street Seeks Credit-Default Safety Net: Banks, Exchanges Speed Effort to Launch Clearinghouse to Back Derivatives Swaps

For those of you who have been reading this blog for awhile or have talked to me for more than 10 minutes about the credit crisis, you probably know that my biggest fear for the markets involves a doomsday scenario where a major institution fails, leaving a variety of counterparties holding CDS contracts without anyone on the other side (earlier post: The Fan).

It seems like one step towards averting such a potential disaster is to have more transparency in this very opaque market so that people can have a better idea about what risks their counterparties are taking.

According to the article:

More than a dozen firms including investment banks, brokerage firms and futures exchanges are accelerating efforts to create a clearing entity that would function as the middleman between firms on both sides of a credit-default swap. The clearinghouse would guarantee payment on the contracts it handles, reducing the risk of a catastrophic ripple effect if one or more firms were unable to make good on their trades.

While there are issues around continued innovation (e.g. the creation of new derivatives), standardization (e.g. which contracts would be used), and internationalization (e.g. people could potentially trade elsewhere), this concept sounds promising.

It is also an excellent example of the market offering a solution to a regulatory failure. Let’s just hope that the Fed keeps their hands off or at least encourages these sophisticated players as they develop this promising market-based solution.

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