What it takes to deal with success: How is the market dealing with the CDS backlog?

PETER NOLAN IS not convinced that buyers and sellers of credit default swaps are fully aware of their exposure. He works for Lysis Financial, dealing with project management in operations and technology for banks that deal in structured credit products. “Banks in the industry are continuously uncovering new exposures to General Motors through credit default swaps,” he warns. “There are risks that people aren’t cognizant of because of old documentation. Every bank is trying to improve its systems but at large organizations there are still legacy trades that are difficult to track. Documentation has altered with the growth in the market and legacy exposure can be hard to work out. How much risk is hiding in those dark corners?”

The question cannot yet be answered. No one predicted that the CDS market would grow as fast it has since its inception in the 1990s and that the infrastructure would not be able to cope with the ballooning volumes. Some market observers even suggest that some trades executed years ago are still unconfirmed.

According to the International Swaps and Derivatives Association, the notional amount of CDS outstanding at the end of 2003 was $3.58 trillion. In June 2005, the figure exceeded $12 trillion. By mid-2006 it is likely to have risen to more than $20 trillion. Global participants in the market are numbered in the thousands and rising, says Isda, with dealers, banks, investment managers, hedge funds, pension funds and insurers all active.

Having a large number of market participants when there is unprocessed documentation can create chaos if there is a credit event. Often the outstanding derivatives notional can be more than the bonds notional so an effective settlement process through exchange of money or bonds is needed to allow trades to settle neatly. In the case of October 2005 bankruptcy Delphi, the total credit derivatives market was about $28 billion, compared with $2.2 billion par of bonds. If there are a sufficient number of outstanding CDS that are not fully matched, there is an increased risk that there will not be an orderly settlement in such cases. “If the settlement were not orderly and effective in its risk mitigation, the risk of legal action to achieve satisfaction would increase and that would damage market growth,” says Mark Beeston, president of trade affirmation service provider T-Zero.

In the autumn of 2005, regulators were forced to recognize the risk that had arisen from the lack of infrastructure in place in the CDS market, and swiftly drew up plans to reduce it. Buyers and sellers have since made significant efforts to improve their systems, and technology providers have been rallying to their aid. How far have we got in establishing a suitable infrastructure?

As the corporate debt market took off in the mid-1990s, credit default swaps began to gain in popularity. Initially insurance contracts taken out on single credits, CDS were bought by banks as protection in the event that companies they were lending to went bankrupt, failed to make payments or restructured. It was an over-the-counter market, with banks entering into privately tailored agreements with customers. Buyers and sellers would affirm trades by phone, with final documentation faxed or emailed through for back offices to confirm that the two sides matched. Initially, when volumes were low, this method was effective. And even though a lack of standard documentation meant frequent discrepancies, these could be ironed out quickly, and confirmations could be processed shortly after a trade.

However, as the market developed, the benefits of using CDS became apparent to a growing number of financial sector participants. Business took off. CDS enabled banks to continue to extend credit to companies they were positive about by using derivatives to reduce the net exposure. The instruments also facilitated balance sheet management. By selling assets and retaining risk through CDS, a user could move assets off a balance sheet and reduce financing needs. CDS enabled banks to hedge assets and reduce capital usage. For investors, CDS enabled access to credit risk that might be difficult to obtain in the traditional bond and loan markets. And above all, the market enabled investors to use leverage. Given that a CDS is an insurance contract, no initial financing is required. So long as the buyer meets the premium payments, he can purchase a CDS.

Too much, too quickly

With an increasing number of counterparties and credits available, CDS volumes rose rapidly. And although Isda sought to standardize documentation to ease matching, and automated matching systems were introduced by such operations as DTCC’s Deriv/SERV and Swapswire in 2003, high volumes made it hard for back offices to deal with documentation and keep track of positions. Between 2003 and the end of 2005, volumes of outstanding CDS increased five-fold. “As an OTC market, it is all too easy to execute a trade, but, prior to Deriv/SERV there was no standard electronic infrastructure in place to facilitate deal matching and confirmation,” says John Burchenal, managing director of asset class expansion at trade management firm Omgeo. “It wasn’t uncommon to see paper contracts piled from the floor to above desk height in the back offices of CDS market participants,” says a senior executive at a US broker.

A growing pile of paperwork Outstanding notional amount of CDSs

Source: Isda