Buy Side Challenges for Centralized Clearing of CDS Contracts

Abstract

OTC derivatives were termed by Warren Buffet as Weapons of Mass destruction, which was earlier much criticized by the financial community. However, these derivatives are now being blamed for the disaster in the financial markets, the bankruptcy of Lehman brothers and the crisis at American International Group. Given the bilateral nature and non standardization of collateral management, OTC derivatives have significant credit risk that may result in the bankruptcy of participating firms. To protect the interest of the OTC derivatives participants, regulatory bodies have given a mandate for the centralized clearing of the CDS contracts.This paper discusses the implications of centralized clearing of CDS contracts for buy side participants and the challenges it poses for them. We specifically discuss the default protection measures taken by CCPs and the ambiguity surrounding the regulatory changes required to implement those measures. The paper details how buy side firms are protected by the margin and collateral management process in the central clearing environment. Additionally, we highlight the changes buy side firms will need to implement in their technology and operations under the new clearing framework.