Exchange-Traded CDS

Alea and Felix have both brought up the slow process of moving CDS trading to exchanges. The primary benefits are pretty clear: reduction in counterparty risk and increased transparency. Trading CDS is like trading OTM puts, naked protection writers would have to put up quite a bit of margin. The solution isn’t that complex, portfolio margining at the exchange level would just need to incorporate a model (KMV-Merton, whatever) to determine greeks and allow hedging with underlying and options on underlying. There was a time when this wasn’t a no-brainer with vanilla options, as well.

The issues brought up on Alea regarding recovery value aren’t that serious I think, although it may require a departure from quoting in spreads or trading CDS contracts altogether. What about something as simple as a future with a basket of deliverable bonds and a fixed coupon? Correct me if I’m wrong, but CDS were created to hedge credit positions (typically in the form of bonds that rarely traded), why mess with all the crap associated with CDS (variable coupon, recovery, events of default, etc.) when we can focus on creating an exchange-traded instrument that solves the original problem.