Credit default swaps: On dangerous ground
Regulators have put huge pressure on the CDS market to address counterparty risk. And the collapse of Lehman Brothers shows why. But in doing so they might be creating a bandwagon that exacerbates rather than solves the problem. Louise Bowman reports.
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.