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CDS: Dead market walking

Rightly or wrongly, credit derivatives will pay the price for failings across the entire credit market.

The credit default swap market now seems to be facing a regulatory backlash so severe that the future viability of the industry as a whole is in question. The market’s frantic efforts to reduce notional outstandings might simply be too little too late, as its image as a hotbed of speculative trading and market manipulation becomes cemented in politicians’ minds. The compression initiatives now under way will certainly reduce the contracts outstanding by a significant amount: Isda has confirmed that volumes decreased from $62.2 trillion to $54.6 trillion in the first half of this year – before the recent events at Fannie, Freddie, Lehman and WaMu even took place. In normal times, a market that shrinks by $7.6 trillion in six months would be remarkable. In these times, however, no one cares. In the public’s mind the CDS market is volatile, opaque, unregulated and out of control – and the regulators are determined to do something about it.

Are credit derivatives guilty as charged? Volatile? Certainly. Following Lehman’s default on September 15, Goldman CDS jumped 150 basis points to 347.5bp, Morgan Stanley 203bp to 479bp, and AIG 820bp to 1,722bp. And the recent behaviour of CDS spreads on insurance companies amply illustrates how these instruments can amplify nervousness to a worrying degree.

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