Moving Towards Exchange-Traded Credit Default Swaps

Ken Griffin wants to move to a system of exchange-traded credit default swaps:

Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.
That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.
"It's not sexy, but it's simple, it's cost forward, its straightforward, and it's what we should have done after 1998," referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it "is a very sad commentary on where we are from a regulatory perspective" that such a move hasn't happened already.
Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. "The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary," he said.

It's a great idea, and I'm all in favor. For one thing, it would cut out the inter-dealer brokers, who cost a huge amount of money, leaving more for everybody else.

What are the obstacles? I don't think it's opposition from the big investment banks - the answer there is to simply get them to set up the new CDS exchange, which could well be worth billions within a couple of years.

There are big problems surrounding the whole issue of counterparty risk. The idea behind an exchange is that if A wants to buy a derivative, he can look at bids from B and from C and take the one quoted at a lower price. That's then the market-clearing price for that contract, and the price can be made public for anybody else who wants to mark their positions to market.

With a CDS, however, A might prefer to do business with C even if C's price is higher, if A has worries about B's reliability as a counterparty.

These problems should not be insurmountable, and indeed a CDS exchange might be able to add a lot of value to the CDS market if the exchange itself somehow licensed its members and guaranteed their obligations. The cost of that counterparty insurance, it seems to me, shouldn't be more than the amount of money currently skimmed off by the inter-dealer brokers.

The difficulty, of course, is how do we get there from here. Griffin blames the US regulators for not having done this already, but it's not obvious whether they're really the ones to do it. Then again, if the regulators don't force the issue, there's a good chance it'll never happen.