Reforms are likely to improve transparency in the market for credit default swaps, say Cleveland Fed researchers
Credit default swaps (CDSs) are a form of insurance against default on a credit, such as a bond or loan, and they play an important role in managing the risk exposures of financial institutions and asset management firms. But a key shortcoming of the over-the-counter (OTC) market infrastructure for CDSs -- lack of transparency-- contributed to the severity of the recent financial crisis. Federal Reserve Bank of Cleveland researchers John Carlson and Margaret Jacobson say reforms being implemented under the authority of Dodd-Frank should improve transparency and make CDS pricing more competitive.
According to Carlson and Jacobson, by 2007, CDS counterparty risk exposures had become embedded in a tangled network of bilateral connections. A buildup in systemic risk went unchecked largely because neither regulators nor market participants could follow the risks being transferred.
Reforms agreed to by the G-20 nations and incorporated into the Dodd-Frank Act aim to improve market transparency. OTC contracts that can be standardized are now required to be cleared at a central counterparty; standardized CDS contracts must trade on regulated exchange-like platforms called swap execution facilities (SEFs); all CDS trade information is required to be reported to a central data repository; and CDS market participants must hold cash in margin accounts as a buffer against changes in CDS valuations.
The researchers say these reforms will allow market participants to see pre- and post-trade pricing. In addition, regulators will have access to information that will allow them to follow the risks as they are transferred and to monitor risk concentrations as they develop.
Federal Reserve Bank of Cleveland
The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.
The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.
Doug Campbell, email@example.com, 513.455.4479