The majority of credit default swaps (CDS) products blamed for adding significant systemic risk to the global financial markets will never be centrally cleared in the US and Europe, concluded a report* by TABB Group.

Central clearing is undergoing considerable change brought on by the domino-like impact of the sub-prime mortgage crisis, the loss of major firms, the seizing of credit markets and the bailout of major banks, according to the report's co-authors Larry Tabb, founder and CEO, and Robert Iati, partner, global head of consulting.

These challenges are exerting pressure on industry participants and regulators to develop a better clearing model. The continuing credit crisis puts the bank community, already disadvantaged by CDS clearing issues, in a vulnerable position with diminished negotiating power to ward off regulators seeking to lower banks' risk profiles and reduce their balance sheets, concluded the report.

The report focused on the most difficult clearing challenges for over-the-counter (OTC) CDS contracts.

Recent exposure to risk in the derivatives markets has fuelled the call for the financial industry to mandate central clearing of derivative products and CDS in particular, said the report which notes that CDS clearing is not straightforward because these agreements can be outstanding for years and need to be risk-managed daily.

"CDS clearing is more about managing risk, margin and workflow than transferring securities title and facilitating payment," said Tabb. "The clearing of CDS is not all homogenous and has different complexity levels. Index-based CDS clearing is much more straightforward than clearing single-name CDS or CDS tranche products."

He said the most significant CDS clearing challenges come from five major issues: product complexity, valuation, liquidity, interoperability and counterparty-risk.

The global nature of CDS also presented a challenge for clearers. "Most clearinghouses are local as members, products and regulators typically are regulated nationally," said Iati. "For clearing of OTC products to succeed, all of the participants must adopt standard contract language, structure, trade matching, affirmation and communication timeframes."

One of the primary challenges for effective global OTC trade clearance global is the lack of consistent access to clearing corporations by potential participants, because scale and critical mass maximise the value of clearing.

TABB Group said it believes there will be CDS central counterparties (CCPs) in the US and Europe for CDS agreements. Dollar-denominated products will most likely be cleared in a US-based and regulated entity and euro-based products will be cleared in a European platform. The larger question revolves around what happens to the European-platform, noted Tabb.

The need for competition in CDS clearing is being driven by six factors: opportunity, jurisdictional squabbles, cost, multiple CDS products, risk mitigation and the fact that dealers do not want to put all of their eggs in one basket, said Iati.

While a single clearing infrastructure is possible, the clearing arena needs enough competition to provide a sound environment that fosters innovation and provides the efficiencies and services required of the changing market place, concluded the report.

The possibility of a single-clearing provider for CDS is extremely remote, concluded the report. The authors believed without the appropriate governance that prevents the risks associated with a monopoly, a single CCP would be an unhealthy outcome.

* Global Credit Default Swap Clearing: Getting the Model Right.