Credit default swaps: On dangerous ground

Credit default swaps: Monolines face litigious and costly endgame

When George Soros describes something as "hanging over the financial markets like a Sword of Damocles that is bound to fall", it warrants attention. This is how he recently characterized the prospect of some CDS counterparties being unable to fulfil their obligations following a credit event or default. "The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves," he added.

These concerns are nothing new – but the bail-out of Bear Stearns in March has pushed them to the top of the agenda. There is a widely held perception that it was Bear’s own credit derivative exposure – and other dealers’ CDS exposure to Bear – that made the Federal Reserve act so swiftly to avert a default. As the majority of trades in the CDS market are dealer to dealer within a small universe of players, it is in all dealers’ interests to make sure that the default of one of their number remains as remote a prospect as possible. As one commentator wryly observed: "The bailout of Bear was equally a bailout of JP Morgan" – because of the likelihood that the latter would have also written protection on the former.

Rightly or wrongly, the CDS market – which has traded uninterrupted throughout the past year, with notional outstandings growing by 37% to $62.2 trillion in the second half of 2007 from $45.5 trillion at mid-year – is now seen as one of the biggest threats to financial stability. It is firmly within the sights of regulators with itchy fingers, anxious to be seen to be proactive rather than reactive to any perceived problems. The market is therefore scrambling to come up with initiatives to placate the politicians before restrictive regulation is forced upon it. It is doing this in two ways: first, by trying to get the outstanding notional size of the market down to a less frightening level; and second, by initiatives to create a central counterparty to stand in the middle of trades and thereby reduce operational counterparty risk. The belief is that this will be enough to satisfy regulators. But two nagging questions remain: is this really as big a problem as the regulators claim? And might not the establishment of a central counterparty create, rather than mitigate, risk by creating a concentrated pool of risk in an entity that becomes too big to fail? "I don’t know of a problem that needs to be addressed with this remedy," declares a 22-year veteran of the CDS market. "This market has done a remarkable job of addressing credit and counterparty risk through master agreements and netting provisions. Two-thirds of the notional out there is collateralized. There is not a problem here. These guys [the regulators] are looking for something to do – they are a patrol in search of a mission."

Notoriously big

The first – and most difficult – thing to do is to establish the true size of the problem; no one can completely agree on how big is the outstanding risk in the CDS market. There is a certain irony in the fact that those same dealers that boasted about the size of the CDS market before last summer are now frantically trying to convince the regulators that it is not anywhere near the size they were trumpeting: that was all double-counting, you see, and there is really not much to worry about after all. The trillion dollar market that CDS has become does not really represent a dangerously unpredictable threat to the financial system because when long and short exposure is all netted off, the real risk is a fraction of this figure, they argue. The only problem with this argument is that no one seems to be able to agree on what that fraction is.

A figure of $62 trillion is a big number by any measure, but new and existing initiatives on netting off trades (whereby long and short trades with the same counterparty effectively cancel each other out) have drastically reduced this total. The Federal Reserve Bank of New York held a meeting during June with 18 dealers in which the industry pledged to reduce the volume of outstanding transactions by multilateral trade terminations, whereby trades can be netted off against all counterparties following the establishment of a central counterparty (CCP). They pledged for the system to be in place by the end of July. Under this tear-up system, all outstanding trades on the same credit with the same counterparty can be compressed into two trades: one standard CDS trade (either short or long) and one fixed recovery trade to reflect the difference in coupon between all the netted-down trades. Markit and Creditex will run this tear-up system, which achieves additional netting off of CDS exposure over and above what is achievable under the Isda Master Agreement. It could mean that the notional principal CDS outstanding is cut by more than one-half. Indeed, if all netting that was possible took place, outstanding risk could be just $2 trillion, according to Isda.

Joint default risk

So, problem solved? Not really. The regulators are not only worried about how much CDS is out there, they are worried about how volatile it will become if the default of a large counterparty looms – and just what would happen if that default actually took place. "There has never been a default in an on-the-run credit index so we just don’t know what would happen," admits Michael Hampden Turner, structured credit strategist at Citi in London. "It could be chaotic."

"One thing that derivatives create is counterparty risk. This needs to be carefully and actively managed" Robert Pickel, Isda