By Laurent Paulhac, CEO, Credit Market Analysis
The credit crunch exposed significant flaws in the infrastructure of the US$62 trillion credit market. The failure of Bear Stearns, in particular, highlighted the importance of reducing counterparty risk through independent, centralised clearing counterparties. Many such counterparties have thrown their hats into the clearing ring of late, without proper discussion as to where they source the prices against which they clear their trades.
One of the largest struggles for institutions is obtaining accurate and timely CDS values against which to trade and perform risk analysis. Due to the lack of a central pricing source in the market, the majority of prices remain opaque. In essence, institutions are reliant on counterparty marks when valuing their portfolios.
Toronto Dominion Bank and Morgan Stanley recently found how perilous this can be: writing down US$94 million and US$120 million respectively due to mismarking of assets. Credit Suisse also recently landed a US$10 million fine for allowing traders to deliberately mis-value their positions. On a broader scale, the UK Financial Services Authority (FSA) has condemned the pricing provided by a large number of banks as “materially flawed or inaccurate”.
What makes these prices so flawed? In essence, sell side prices constitute a stab at a real price, a ‘mark to myth’, rather than a mark to market. They are, simply, the prices at which people wish to sell. Much like selling a home, sellers may post for one cost, though the market is willing to pay another. Because a centralised and independent sell price cannot be verified, it is dangerous to assume the sell side price is accurate. Morgan Stanley and Toronto Dominion discovered just this in the above scenario; when ready to close out their positions, they discovered that they were worth far less than predicted.
Furthermore, typical sell side pricing is outdated, based on information contributed by market makers from their books and records, and bearing little relation to today’s tradable value. In passing, CMA clients have suggested that in excess of 50% of prices received from dealers are rejected as being so inaccurate as to be unusable. If these values are integrated into any future CDS clearing house, the entire market runs the risk of being infected by stale and untrustworthy data. This will be particularly dangerous in volatile markets when dramatic intraday fluctuations occur.
CMA, a subsidiary of CME Group, provides software and data that enable hedge funds and institutional investors to gain price transparency in illiquid and unregulated markets and efficiently manage their risk exposure in portfolios containing complex credit derivatives. CMA is also the official pricing partner for the CBOT CDR Liquid 50 credit index.
CMA believes that the buy side is the best source of up to the-minute price information, as it is unencumbered by vested interests and is closest to the trading action. For that reason CMA has developed a consortium of more than 30 of the largest and most sophisticated credit investors in the world (hedge funds, banks and asset managers) whose front offices contribute the tradable prices they observe in the market.
After a sophisticated aggregation and cleaning process, CMA publishes a same day, buy side consensus-based, price verification file (DataVision) allowing investors and risk managers to assess their positions with the freshest data available. The model is widely supported by buy side institutions, as DataVision values are closer to market values than those from the sell side. An intraday service is planned in the near future.
CMA believes that the quality of the pricing data used in a central clearing counterparty will be one of the core factors contributing to its success. Integrating a buy side orientated approach to a central clearing house will have huge benefits for the market. In addition to reducing counterparty risk and adding transparency, investors can have confidence that their trades are cleared against reliable, timely and independent values.
In short, origins count. High quality outputs are reliant on high quality inputs. As the contenders for a centralised clearing platform emerge we encourage close scrutiny of the price sources used in the clearing process in order that reducing counterparty risk does not come at the cost of increased pricing risk.