Curbing Swaps Correlation Risk Vital, Regulators Told

Regulators need to consider the collective risk of the credit-default swap market when deciding margin requirements for cleared trades, University of Houston finance professor Craig Pirrong said today in Washington.

The correlation risk that much of the market -- or companies within the same industry -- deteriorate in lockstep must be taken into account, Pirrong said today at a public roundtable on credit-default swap clearing sponsored by the Commodity Futures Trading Commission and the Securities and Exchange Commission.

“That’s another issue regulators have to be particularly aware of going forward,” he said. Clearinghouses are accustomed to thinking of margin, or the cash investors must put up to back derivatives trades, on a contract by contract basis, Pirrong said.

Unregulated over-the-counter derivatives complicated efforts to solve the financial crisis two years ago when regulators struggled to determined how connected banks had become by trading the contracts and whether it could lead to a chain reaction of failures. A measure of market perceptions of default correlation soared in 2008 to record levels amid the crisis, as did the cost to protect against bank defaults.

New Regulations

The Dodd-Frank bill, which became law in July, regulates OTC derivatives such as credit swaps for the first time in the market’s 30-year history. In most cases the CFTC and SEC have until July 2011 to write new guidelines, under which most interest-rate, credit-default and other swaps will be processed by clearinghouses after being traded on exchanges or swap-execution facilities.

Clearinghouse margins do account for correlation among industry groups and concentration of trades within a specific group, Athanassios Diplas, global head of systemic risk management for global credit trading at Deutsche Bank AG (DBK) in New York, said at the roundtable.

The clearinghouses so far are only backing swaps on companies in industries that are the least volatile, Diplas said. Industries where correlation and concentration risks are greater -- such as with banks and sovereigns -- will need further study, he said.

“That’s where a lot more work needs to take place,” he said of clearing swaps on financial companies. “The same issue exists with sovereigns. Deutsche Bank will not trade Germany CDS. That’s a very obvious example.”

Correlation among financial firms is “by far the biggest” among industries, Pirrong said.

Daily Margin

Clearinghouses, which are capitalized by their members, are meant to reduce systemic risk by absorbing and sharing responsibility if a member defaults on its payment obligations. They use daily margin calls to keep accounts current and provide regulators with access to prices and positions.

Intercontinental Exchange Inc.’s ICE Trust, the largest credit-default swap clearinghouse, has been clearing trades since last year and has processed about $7 trillion in index contracts and $467 billion in swaps linked to single companies. LCH.Clearnet Group Ltd. and CME Group Inc. also offer credit swap clearing.

Credit-default swaps contributed to the financial crisis when they were used as a substitute for betting on pooled mortgages after new home loans dried up. Losses from the swaps totaled $66.7 billion from the third quarter of 2007 through Oct. 18, according to data compiled by Bloomberg, or 3.7 percent of the $1.83 trillion in writedowns.

Jump-to-Default Risk

Credit swaps pose a potentially unique challenge to clearinghouses because of the jump-to-default risk associated with single-name contracts written on corporations. Swaps on Morgan Stanley (MS) soared 736 basis points in the three days after Lehman Brothers Holdings Inc. filed for bankruptcy in September 2008.

That level of volatility has never been tested in a swaps clearinghouse, which would have to put resilient margin systems in place to keep investor positions current during such price swings. Futures clearinghouses typically increase the amount of margin required to back trades as volatility rises. Swings in natural gas futures prices, another volatile cleared product, have bankrupted investors who couldn’t meet margin calls.

Asked how the clearinghouses are dealing with jump-to-default risk of credit swaps, Stan Ivanov, chief risk oficer of the Clearing Corp., an Intercontinental unit, said in some cases the margin could approach the total amount of notional value of a credit swap. “We have very specific concentration charges,” he said.

Different Approaches

Ananda Radhakrishnan, director of the CFTC’s Division of Clearing & Intermediary Oversight, asked the panelists if margin on the same product at different clearinghouses could be different and whether the commission should set uniform margins for all clearinghouses.

There is room for different approaches to margining the same contract at different clearinghouses, said Kim Taylor, president of CME Group’s credit-swaps clearinghouse. Depending on how varied the set of cleared products is, a clearinghouse could choose to margin a trade at varying levels, for example, she said.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point, 0.01 percentage point, equals $1,000 annually on a contract protecting $10 million of debt.

The market peaked at $62.1 trillion in notional value in the second half of 2007, and totaled $30.4 trillion at the end of last year, according to a market survey by the International Swaps and Derivatives Association, a trade and lobbying group. The notional amounts of OTC derivatives contracts are used to calculate regular payments between trading parties and don’t represent money that has changed hands.

To contact the reporters on this story: Matthew Leising in New York at; Shannon D. Harrington in New York at

To contact the editor responsible for this story: Alan Goldstein at

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