Cross-asset class approach
Darrell Duffie and Haoxiang Zhu of Stanford Graduate School of Business have argued proposals for derivatives clearing become more attractive from a counterparty risk reduction perspective if a single CCP handles clearing for all large global dealers in Europe and the US. Ideally, credit derivatives should be cleared together with interest-rate swaps in the same central clearing counterparty, they said.
Carving off a particular class of derivatives for clearing only makes sense if the volumes and the numbers of dealers involved are big enough. "It would be hard to base a case for the netting benefits of a CCP dedicated to CDS on the magnitudes of OTC derivatives credit exposures," Duffie and Zhu said.
Credit derivatives currently account for about 8% of total gross exposures. Together, interest rate swaps and CDS represent around 60% of the total gross exposures of dealers in the OTC derivatives markets.
"One could argue that CDS exposure is rather special, because of jump-to-default risk and because default risk tends to be correlated with systemic risk," they added. They found jump-to-default risk was better reduced through bilateral netting.
A CCP that can clear both credit derivatives and interest rate swaps would offer more significant reductions in counterparty risk, even if a relatively small number of derivatives dealers participated in the venture, Duffie and Zhu’s paper concluded.