They keep holding meetings with the three competing industry vendors that are trying to build a credit default swap clearing house. Everyone agrees that some sort of clearing house mechanism would have made the market much safer due to the ability to reduce risk to its multilaterally netted mark to market component, collateralization of this net risk, and price transparency.

I assume what is behind the Fed's thinking is we can take all the existing CDSs, and maybe CDOs too, and run them through this clearing house to achieve all three of these objectives. Here are two problems with that.

First, these clearing houses are hideously expensive and only work if there is industry consensus to join. Someone among the three has to be anointed because otherwise it takes years to shake out competitively which one gets the nod. Complicating this is which regulator gets to oversee the clearing house, and the Fed is playing hard ball by trying to force these vendors to accept NY for location, NY law for the netting, and the Fed as regulator. Behind the scenes, the ECB may be jockeying for a role, and frankly the Fed's position on these issues is weakened given the collapse of the financial markets in the US.

Second, it is not clear that CDSs and CDOs are viable products in the future. They existed because the risk in the products was grossly underestimated, and because traders were allowed to overtrade and layer risk on to a small pool of underlying bonds. These conditions will not be allowed to repeat, so in that sense there is no product in the future to generate the volumes and fees to justify a clearing house. That doesn't stop the vendors from competing to create one, because they already have significant sunk costs, and they are probably hoping the products will survive in a very basic, plain vanilla form.

What to do? What you need here is a fancy risk reduction system, an agreement on international law, and all the top players around the table to create a multilaterally netted exposure for the entire group, without going to the trouble of creating an actual clearing house. The netting system or model probably exists in prototype form among the vendors. The top players are now wards of the government, especially AIG as principal counterparty to everybody. The netting law is strongest in the US so agreement can probably be reached on risk reduction through the NY courts. Considering therefore that the CDS and CDO market is frozen and that we are really dealing with eliminating the risk in existing contracts, and not having to worry about new contracts coming onstream, the Fed should organize a netting party without a clearing house.

The way this could be done is to select a prototype system that can analyze the trades as one giant pool of transactions, most of which offset each other. Conduct the netting exercise. Show each player what will happen to them if they carry on as is, and one of the others goes bankrupt. Everybody will suffer whatever large losses exist under existing bilateral netting agreements with the defaulter. Next, show everybody what the losses will be if they all agree to multilaterally net their exposures and collateralize them collectively. The losses will be a fraction of the bilateral number if one of them goes down. The advantage to this method is that the regulators can also see from this analysis what the true systemic risk is. In other words, if nothing is done and everyone has to take a bilateral hit on one default, which of them will be dragged down as well by the bilateral hit? What is the daisy chain of systemic defaults that could occur? This would give all the regulators huge incentive to multilaterally net these exposures and force any recalcitrant banks to join in the pool.

I don't want to minimize the complications of this, since these default swaps are bespoke contracts. There are probably thousands of unique trades that will have no offsetting position other than bilaterally, and prices will be hard to agree upon. But where there is a will, there will be a way. The Lehman settlement showed that the net payable in default can be manageable for the industry and price discovery can be achieved.

the present form of them is not. A CDO, really, s just a security with different streams that make up it's debt payments. It is no different form a conglomerate or other multi-sourced stream of income, including a currency or a mutual fund. The problem with CDOs as they exist now is that the root of almost every CDO that actually got created, was the carry trade. In one way or another, the entire basket of revenue inany CD, rested on super cheap money from someplace, which was then marked up because the people borrowing could not get access to special lending of one form or another.

As a result, the CDO's didn't, in fact, diversify systematic risk, because at the bottom, was the same systematic risk: the carry trade itself. The risk there was thatat some point a few key rents would absorb all of the profits globally, and the carry trade would have to cease. This happened earlier this year, and the entire structure fell apart.

CDS' meant to turn these into investment grade securities, were also predicated on the carry trade. Hence buying a CDS to remove systematic risk, in fact increased systematic risk.

Key to this process was the corruption of the rating agencies, which consistently rated securities that were not investment grade, as investment grade. They dragged their heels, for a host of reasons.

What needs to happen is that yes, there needs to be a market for theseinstruments, but that most instruments of the kind that exist arealmost valueless as they are created. We need to go through a process of disentanglement, much as trust busting and the stock market crash of 1929-1932 basically reset American capitalism to 0, and unwound assets that had no business being put together in the first place.

European CDS-market is bigger than the US market.

They are not going away, but the market place needs to be regulated.

CDS is like a put option on a bond.

Normally regulators do not ask why somebody buys or sells something because of trade secrets, but certainly they ask if the buyer/seller can take care of their obligations.

Credit Default Swaps: Bad Enough to Ban?

Ban of CDS gains Traction references this thread and has a some interesting links of its own

Since I've only started reading about CDSs with the onset of the credit crisis, I'd like to make sure I understand how they work. My take is that, at least relative to recent mortgage-based finance, they are in effect bets masquerading as insurance policies against bond default, since they aren't regulated (no actuarial analysis, reserve requirements, etc.). I also understand that the issuers of these policies can sell their shares to third parties with the agreement that, if the bonds in question hold out, the issuers simply pass on quarterly premiums to the third parties, and, if the bonds default, the issuers bill the third parties after paying off the insurance purchasers. Likewise purchasers can sell their shares in the same way. Since these agreements can pass through multiple hands, the overall risk escalates that a chain reaction of worthless instruments could be unleashed if one or more parties in the chain can't make good on their commitment. Since these transactions are unregulated, it becomes difficult to know how much any given CDS is really worth. Is this an accurate description?

that requires all writers and buyers of CDSs to disclose everything. No?

Is that the govt figures why penalize the rich when there are plenty of tax paying poor just waiting to pick up the tab? So far no one is griping loud enough so that is the MO. I don't know if that is the thinking going on in DC, but it certainly feels that way from the outside.