Central Clearing of Derivatives: Liquid versus Illiquid Underlying

A short research piece by Orçun Kaya at Deutsche Bank, “Liquidity is key for the central clearing of derivatives” (March 12, 2015) is worth reading. Kaya looks at where central clearing is likely to be successful and where it may not.

Interest rates swaps have a lot of traction already. Less liquid assets like single name credit default swaps – not so much.

“…The FSB (2014) estimates that globally around 50% of interest rate swaps (IRSs) are centrally cleared, up from 30% in 2011. For single-name credit default swaps (CDSs) the share of centrally cleared products stands at around 20%, up from 5% in 2010. On the other hand, the non-cleared segment of the derivatives market mainly includes illiquid or bespoke products for which it is difficult to appropriately implement margin practices. Against this background, CCPs may shy away from clearing these products. For market participants, though, knowing which spectrum of products is suitable for central clearing is hugely important for future risk management and hedging practices…”

But taking a closer look at the less liquid sector, Kaya examines which characteristics encourage central clearing and which go the other way.

Liquidity: the higher the liquidity (as measured by traded volume), the more likely the specific CDS contract is to be centrally cleared.

“…The large impact of liquidity is consistent with the risk management practices of CCPs: in case of a counterparty default, strong liquidity characteristics of the CDS are crucial for enabling the portfolio of the defaulting clearing member to be managed in a timely and efficient manner…”


“…a moderate increase in the daily price volatility of the CDS lowers the probability of a product being centrally cleared…”

 The risk management at central clearers recognize that instruments like single name CDS are difficult to manage. Jump to default risks require (appropriately) higher IM. The more volatile the underlying, the more frequently the VM is adjusted. These discourage market participants from centrally clearing these instruments.

There are company specific factors too. “…the indebtedness (profitability) of the underlying firm has a negative (positive) impact on CCPs’ clearing decision…”. The higher the indebtedness, the lower the chance of being centrally cleared. On the other hand, the more profitable the underlying reference issuers, the more likely it will be centrally cleared.

Kaya notes that with the increases in non-cleared margin making those products more expensive, and reluctance to centrally clear less liquid products, this double-whammy may make single name CDS go extinct.

“…Considering the fact that after the full implementation of the recent derivatives market reforms, margin requirements for non-centrally cleared products will be prohibitively high, the pricing of some (OTC) derivatives may not be attractive anymore and those will probably vanish from the market…”

In fact, back in November, 2014 Deutsche Bank has stopped trading single name CDS.

With central clearing expanding its footprint in repo in the coming year, it is good to remember that the focus should be on liquid underlying.

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