Prevent OTC Credit Default Swap Blowups; Put CDS on an Exchange!

When JPMorgan announced a few weeks ago that its chief investment office lost $2 billion+ on large complex "synthetic credit" positions (and possibly a few more billion as they unwind trades), Tim Backshall, founding partner of Capital Context, told CNBC's Rick Santelli that credit derivative blowups at too-big-to-fail banks would be prevented if credit default swaps were put on an exchange. Simple as that.

Rick Santelli (CNBC): How could we correct this rather quickly, you have an idea?

Tim Backshall (Capital Context): "Well, it would be very simple, and coming from a credit guy it's a little bit odd to say. The bottom line is you could put so much of the credit derivative market on an exchange within a few days. It already trades electronically for the most liquid indices. Of course there are complex and ad hoc, or OTC positions that would be very hard to do, but they can be managed in a different way." (not from an official transcript)

The International Financing Review found Federal Reserve data on JPMorgan's "synthetic credit" exposure as of Q1.

view chart at IFR
"In investment-grade CDS with a maturity of one-year or less, JP Morgan’s net short position rocketed from US$3.6bn notional at the end of September 2011 to US$54bn at the end of the first quarter. Over the same period, JP Morgan’s long position in investment grade CDS with a maturity of more than five years leapt five times from US$24bn to US$102bn (see chart)."

And just think, back in 2006, credit derivatives could have been placed on exchanges before the banks and whole financial system crashed in 2008. Investment banks would lose big money if credit default swaps were put on exchanges. So you can understand why six years and few government bailouts later, they still trade OTC. From

"Exchange-Traded Credit Derivatives Poised to Curb Bank Monopoly By John Glover and Hamish Risk - December 11, 2006 19:18 EST Dec. 12 (Bloomberg) -- Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. risk losing their hammerlock on the most lucrative financial market when exchanges begin offering credit derivatives next year. Paris-based Euronext NV, which is being bought by NYSE Group Inc., plans to create contracts based on credit-default swaps, making them cheaper to trade and easier to understand than the derivatives sold by banks. Credit-default swaps, used to speculate on credit quality, also top the product list for Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt- based Eurex AG. At stake are profits from the fastest growing financial market as exchanges list credit-default swaps alongside stocks, currencies and gold. Deutsche Bank says it earned at least $3 billion from credit derivatives in the first half of this year, about a third of total revenue from financial markets."

And from an article at TheOptionsInsider:

"Face Off Against the Credit Derivatives Cabal Posted on 3/30/2007 in Trading & Technology by Mark S. Longo THE DELUGE The subprime lending debacle has triggered a flood of interest in hedging and trading credit risk. Unfortunately, credit derivatives are primarily limited to the over-the-counter (OTC) market. This puts them out of the reach of most retail investors and more than a few institutional traders. However, with the value of the credit derivatives market pushing $27 trillion, it was only a matter of time until the derivatives exchanges tried to get in on the act."

Cash bonds should be on exchanges as well, with an easy way to short and hedge. But somehow synthetic credit (CDS), which is only available to institutional investors, took over the real credit market. It seems like too-big-to-fail Wall Street banks run the two most inefficient, opaque, illiquid, and most important markets in the world: OTC credit and credit derivatives (loans, bonds, mortgage-backed-securities, CDOs, credit default swaps...).  For example, a month before the second article was published above, Goldman Sachs was pitching the $2 billion Abacus synthetic CDO that referenced subprime mortgage-backed-securities to clients. For this "monstrosity" of a transaction to take place, Goldman needed to find a buyer (aka credit default swap seller) and a seller (credit default swap buyer) of the synthetic CDO's subprime MBS exposure. Look how complicated this is. We are talking about mortgages here. In the end, hedge fund Pauslon & Co. made big money on the short side, and foreign banks IKB and RBS lost their shirts on the long side. It seems like this transaction could have been chopped up and put on exchanges. Look, on the NASDAQ OMX Nordic exchange (Denmark) people can trade mortgage bonds, government bonds, structured bonds, corporate bonds, and fixed income derivatives.

Source: Business Insider

Why can't we cut the notional value of bonds and credit default swaps and put them all on exchanges like stocks and options. It would make the credit market more liquid, transparent, and available to all investors. Yes, college kids could be mini-AIGs, but what is the difference between losing money on an fraudulent OTC penny stock and getting a margin call on a mini-CDS position by a discount online broker? Here are related posts on CDS on my blog. I'm waiting to see charts on and

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