What About Those Swaps?

Last week's Wall Street Journal of Wednesday, November 12, sounded an alarm regarding AIG's continuing credit default swaps positions.

However, just this week, a Journal article contended that, of all the malfunctioning fixed-income markets, the CDS market had actually done remarkably well during the past few months, including settling the now-defunct Lehman positions.

According to the editorial, CDS pricing now provides a better, more continuous measure of the value of debt of many firms than their own, non-trading debt does.

Even so, I can't help but believe that the CDS market would do better in the future if two things were changed, as I have suggested in prior posts: create a formal exchange, and; restrict the leverage allowed for entities holding and trading CDS.

The first change would provide greater transparency for many aspects of the CDS market, including gross and net outstanding volumes, trading volumes, and a better identification of the major players who, therefore, are exposed to risk in the market.

The second change would limit the damage to the CDS market and, by extension, to other markets, by assuring the availability of equity for CDS positions which require more collateral, as could be required by the exchange on an intra-day basis.

Together, these improvements would limit the likelihood that another mess like that which consumed AIG could occur. Exchanges monitor the financial ability of members to fulfill their obligations to other members, which would have provided a more public warning regarding AIG's over-extension in CDSs.

I don't doubt the CDS market is vital. But leaving it to exist as an over-the-counter market with no clear rules or standard clearing mechanisms invites another disaster by another firm as inept as AIG was at correctly assessing its risks under the many billions of dollars worth of securities price protection it sold as CDSs.