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CBOE Plans CDS Challenge With Credit-Default Options

Senator Chris  Dodd and Rep. Barney Frank
Senator Christopher "Chris" Dodd, a Democrat from Connecticut and Senate Banking Committee Chairman, right, speaks at a news conference with Representative Barney Frank. Photographer: Andrew Harrer/Bloomberg

CBOE Holdings Inc. is seeking to resurrect credit-default options, or contracts that pay off when companies fail to repay their debt, as regulators try to shift some trading of over-the-counter derivatives onto exchanges.

The owner of the largest U.S. options exchange first created the derivatives in 2007. Trading volume amounted to 56 contracts in 2007 and 2008, and none changed hands last year, CBOE said. To generate interest, the settlement price for contracts would be less than the $100,000 value on the original options, according to a proposal filed with the U.S. Securities and Exchange Commission.

CBOE is trying to win business from the $29.6 trillion credit-default swap market, where contracts are traded over the counter. Among changes mandated by the Dodd-Frank Act, signed into law in July, are requirements that standardized interest-rate, credit-default and other swaps be processed by clearinghouses and traded on exchanges or similar systems.

“They’re dusting off the rules and changing the trading protocols to allow them to manage the instrument more to meet market demand and conditions,” said Andy Nybo, head of derivatives at financial services research firm Tabb Group LLC in New York. “If it builds liquidity, it’ll attract more speculative trading strategies from hedge funds and proprietary trading accounts, but that’ll take deep, two-sided markets with active support from market makers.”

‘Simply Won’t Develop’

In its filing with the SEC, CBOE didn’t say whether market makers would facilitate trading in the credit-default options. New York-based Jane Street Specialists LLC was the market maker for the earlier product.

“The biggest challenge is to build liquidity and get market participants to trade the instruments,” Nybo said. “Until you do that, the marketplace simply won’t develop.”

CBOE also proposed altering rules about how the contracts settle and what constitutes a credit event, which determines whether the product has a payout. CBOE plans to change the increment by which quotes in credit options can move to allow for bids and offers at more prices. The exchange told the SEC that “more pricing points” would decrease the spread, or difference between bid and offer prices, which would benefit investors by enabling them to sell a contract for more money and buy at a cheaper price.

Bankruptcy Insurance

The options, like credit-default swaps, will give buyers insurance against a company filing for bankruptcy. Privately negotiated credit-default swaps pay the buyer face value if a borrower defaults minus the value of the defaulted debt. A basis point, or 0.01 percentage point, equals $1,000 a year on a contract protecting $10 million of debt for five years.

Unlike over-the-counter products, those traded on exchanges are usually standardized and cleared by an organization that guarantees the contract will settle. A clearinghouse, by acting as the central counterparty to every buy and sell order they process, reduces the risk that could result if a trading firm defaults on its obligation in a transaction. Clearinghouses are funded by their members, who must meet capital requirements and pass operational and technology tests.

“When you have liquid public markets, it provides information to investors that might otherwise be obscured to their view,” said Michael McCarty, managing partner at Differential Research LLC in New York, which advises investors on volatility strategies. “It basically just makes the playing field more level.”

Settling Contracts

Options Clearing Corp., the Chicago-based organization that clears and settles all trading of exchange-listed contracts, got SEC approval in 2007 to handle credit options from the CBOE.

“It is not uncommon for derivative contracts that are initially developed in the OTC market to become exchange-traded, as the market for the product matures,” James Overdahl, the SEC’s former chief economist, said in testimony before the Senate Banking Committee in July 2008. He cited CBOE’s credit default options product as an example of this.

“Exchange trading of credit derivatives would add both pre- and post-trade transparency to the market which could add credibility to the pricing of credit derivatives,” Overdahl said at the time. He left the SEC earlier this year and is now a vice president at NERA Economic Consulting in Washington.

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