Around 60 percent of the $24.8 trillion credit derivatives market can rapidly move to central clearing and reduce systemic risk, but moving much beyond that could be counterproductive, according to market experts.
If overzealous regulators drive central clearing houses to take much more than that, they could end up actually increasing risk in the global financial system, bankers and analysts said.
Regulators are pushing the market to move to central clearing of credit default swaps, which have been blamed for contributing to the financial crisis. Significant strides have been made so far, with most index trades already going through central counterparties.
UBS estimated that 60 percent of credit default swaps (CDS) are currently clearable after assessing the CDS it trades.
"Let's not penalize ourselves by trying to push a market that doesn't work that way into this structure, creating more risk that doesn't help anybody," said Stu Taylor, a managing director in fixed income at UBS.
This week, clearinghouses urged lawmakers not to recklessly force inappropriate products through them.
Used for decades in liquid markets such as equities and foreign exchange, clearing houses step in following a trade to take the counterparty risk for both sides.
They reduce risk by netting out the offsetting short and long positions of multiple players. The derivatives industry has created standardized contracts to enable netting, but investors have not moved all old CDS to the new contracts.
Clearing houses also minimize risk by adjusting counterparties' collateral daily to reflect market values, which means CDS must trade frequently for confidence in pricing.
CITIGROUP ESTIMATES
At Citigroup, traders estimate that 70 to 80 percent of the market is clearable, but it will take at least two or three years to reach that number due to clearers' operational constraints, said credit strategist Michael Hampden-Turner.
Several clearing houses declined to comment. They will be reluctant to commit to any specific number, Hampden-Turner said.
IntercontinentalExchange Inc. (ICE.N) is the only player so far to have cleared a substantial volume of CDS.
Its web site showed ICE has cleared about $7.1 trillion in CDS, about 29 percent of the $24.8 trillion total shown by the Depository Trust and Clearing Corp (DTCC) as of April 2.
Indexes accounted for $6.7 trillion, indicating ICE is likely to already cover what is clearable of the $7.3 trillion index total.
An area not yet tackled by clearers is one of the most complex. Nearly half of the $2.7 trillion market in so-called tranches consists of bespoke deals created for investors before the crisis and is not suitable for clearing. Analysts estimate around $1 trillion in standard tranches is clearable.
The biggest uncleared part of the market, however, is the $14.9 trillion in CDS for single corporate names, with the 1,000 largest names accounting for $13.7 trillion of that.
ICE has reached less than $360 billion in single names.
"The main question is single names, and the key bit is liquidity," Hampden-Turner said. "By clearing the top 200 most liquid names out of the 2,000 or so that trade, clearers should be able to get to the 50 percent level pretty quickly."
More than 460 of the largest names are liquid enough to eventually be cleared, he estimated.
Over time, the clearable portion of the market is bound to increase as old, illiquid contracts expire and clients gravitate toward cleared products, knowing they are more liquid.
Furthermore, proposed new banking regulation, dubbed Basel III, includes a provision requiring banks to hold capital reserves against all CDS, not just net exposure, Hampden-Turner said. That means trading in CDS contracts that are not cleared would become much more expensive
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