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CAPITAL MARKETS

Credit default swaps: CDS market faces up to a new reality

The CDS market is trying to withstand the strain of three almost simultaneous counterparty defaults.

Regulators and practitioners alike have spent much of 2008 fretting about how the CDS market would perform in the event of a big counterparty default (see Credit default swaps: On dangerous groundEuromoney, August 2008). Last month the system was more than put to the test when credit events triggered the unwind of not one but three big CDS counterparties. The "conservatorship" of mortgage agencies Fannie Mae and Freddie Mac rapidly followed by the bankruptcy of Lehman Brothers has placed more of a strain on the infrastructure of the CDS market than anyone – even its harshest critics – could have expected it to deal with.

According to Citi analysts there is roughly $200 billion of index CDS outstanding that references Fannie and Freddie and $300 billion in single-name exposure. They also estimate $200 billion in tranche exposure for Lehman, which gives a ballpark estimate of $700 billion in gross notional to be settled. And that is before the implications of JPMorgan’s Washington Mutual takeover are factored in.

Opinions are divided as to just how the market is functioning with this processing challenge. "There are a lot of outstanding contracts for which value must be established [each non-defaulting party has the right to establish the value of the contract through the Isda auction process].