The Economist’s Cheery View of Credit Default Swaps

It’s remarkable how attending an industry love-fest can distort one’s perception. The Economist seems to have fallen hook, line, and sinker for International Swaps and Derivatives Association view that counterparty risk in the credit default swaps market isn’t all that big an issue.

Its article, “Clearing the fog.” while mentioning the little problem that led to Bear’s gunshot wedding, manages to quickly brush by it. It does provide useful detail on the plans to establish a clearinghouse, but fails to mention that this initiative is to forestall regulation.

Nevertheless, several aspects of the story struck me as odd, and I’m curious to get a sanity check from informed readers:

1. It says that the amount of CDS outstanding at the time of the Delphi bankruptcy was 30X the face value of cash bonds. The number I’ve seen repeatedly is 12X. Has anyone seen/heard this 30X from a credible source?

2. The clearinghouse would provide netting of “offsetting” contracts. While that is a standard clearinghouse function, will that be easier said than done given the offsets are often pretty approximate? Put it more simply, are the valuation issues related to a netting operation generally trivial or not?

3. The article mentions rather casually that 13% of the CDS trades were unconfirmed as of last December. That strikes me as a horrific number.

4. The piece (at least as I read it) fails to give readers a sense of how manual the settlement of CDS trades often is.

And then we have the big question that is only indirectly triggered by the article:

5. Why are CDS outstanding growing so quickly? The Financial Times reported they grew from $34.8 trillion to $62 trillion outstanding in a single year.

Structured credit and CDO issues, which can use CDS for credit enhancement, slowed down considerably in the second half of 2007 and is close to moribund this year. There hasn’t been much in the way of corporate bond issues. One motivation for more CDS activity would be the expectation that more corporations, particularly the ones that already have junk ratings, might default or at least become distressed. That would lead to much more CDS issuance on existing reference entities.

But the increase is still attention-grabbing. Is the main reason simply that firms are adjusting their risk exposures in light of the new nervous environment, and it’s easier to do that via entering into new CDS contracts than by trying to trade your way out of your position(s)? If so, the amount CDS written will inevitably mushroom, even though the underlying credits expand no where near as rapidly. Although I can’t prove it, a market like that seems destined to fall over.

From the Economist:

Bankers gathering in Vienna this week for the annual bash of the International Swaps and Derivatives Association (ISDA) had some big numbers to celebrate. The overall market for over-the-counter derivatives shot up to $455 trillion at the end of 2007. Some $62 trillion of that were credit-default swaps (CDSs), whose supercharged growth continues in spite of the crunch. But the emphasis this year was as much on playing down dangers as playing up volumes. ISDA was quick to point out that actual credit exposure was a mere 2% of the notional value of all contracts.

This coyness is hardly surprising. Regulators have been fretting since 2005 that the market’s infrastructure was not keeping up with its growth. Then, in March, came the sudden implosion of Bear Stearns, a top-ten actor in CDSs, rescued partly because of the fear of chaos if such a large counterparty were to fold. The market’s overseers may not agree with Christopher Whalen of Institutional Risk Analytics, a consultancy, when he describes off-exchange derivatives as an “act of Satan”. But they want to see more robustness, especially in credit derivatives, and have hinted that they will impose their own solution if the market does not.

Conceived in the 1990s as a hedging tool, CDSs soon took off as a way to speculate on the likelihood of a firm going bust without having to trade its underlying bonds. For much of this decade, they have been celebrated as a means of spreading risk around the financial system. However, their rampant success led to processing backlogs and errors. Under pressure from the Federal Reserve Bank of New York and others, the industry accelerated trade automation and clarified the rules of engagement (for instance, making sure banks were notified when the firm on the other side of the trade sold its interest to another party).

But problems remain. A rise in late confirmations accompanied the spike in trading last summer, suggesting that the plumbing still lacks scalability (see chart). As of December, 13% of outstanding CDS trades were unconfirmed. Technology vendors say solutions exist, but banks and supervisors have been slow to adopt a standard. “It’s like the world is starving and we’re just standing here with the rice,” says the chief executive of one derivatives-software firm.

Regulators also want to see cash settlement, rather than physical delivery of bonds, built into standard documentation. Physical delivery could distort prices as defaults rise, because the value of derivative positions far exceeds the face value of the corporate debt they reference—by 30 times in the case of Delphi, a car-parts maker that filed for bankruptcy in 2005

Major dealers, responding to regulatory threats in March with a letter to the Fed, gave themselves an ambitious set of targets to be reached this year. They include reducing the backlog of contracts still unconfirmed after 30 days and increasingly “warehousing” data about trades with the Depository Trust Clearing Corporation (DTCC), for added safety.

Another goal is to move towards reducing counterparty credit risk by clearing deals though a central counterparty—the sort of job DTCC does in American cash markets. A group of large dealers plans to start offering such a service later this year through the Chicago-based Clearing Corporation. Kevin McClear, the firm’s chief operating officer, points to several benefits: a credible counterparty, regulated by the Commodity Futures Trading Commission, at the heart of every trade; more scope to reduce the overall amount at risk by “netting” offsetting contracts; and greater capital efficiency, since if the exchange were the counterparty, the banks’ exposure could have a zero risk weighting.

Exchanges, for whom this sort of thing is bread and butter, spy an opportunity too. NYSE Euronext and CME Group, which runs the biggest futures exchange, are among those working on plans to offer over-the-counter clearing for credit derivatives. The CME has already made modest headway in interest-rate swaps.

Ultimately, the bourses hope to turn credit derivatives into exchange-traded products. The potential benefits—including transparency and much lower transaction costs—are clear. But there are formidable obstacles: the big dealers will fight it, because it will rob them of the outsized fees they get from bespoke deals—over 90% of their total derivatives-trading revenue, by one estimate. Also, fixed-income derivatives tend to be more arcane than shares, are traded in larger sizes, and there are many more varieties of them. Thus, in many cases, they might be resistant to the sort of standardisation that is necessary for exchange trading. Past attempts to trade credit derivatives on bourses have flopped.

Still, that is the direction in which the market is inching, with a (for now) gentle helping hand from regulators. Mr Whalen thinks moneymen will get better at replicating complex CDSs using exchange-traded credit products combined with options. “It’s no slam dunk,” says the CME’s Kim Taylor. “But it looks like a great long-term opportunity.”

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  1. Anonymous

    Geat point you make:

    “…and it’s easier to do that via entering into new CDS contracts than by trying to trade your way out of your position(s)?”

    So, insure your way to profit.

    This is just more evidence that the System is Mutating in order to survive a Hostile Environment. And Mutation is unpredictable and uncontrollable.

    And investors should ask: do you want your assets connected to a Mutating Financial System?

    Soon, what are now Windows will mutate to Garage Doors.

  2. RK

    In a Feb. 2008 article, Gretchen (why does Tanta hate me) Morgenstern cites a 10 to 1 ratio for Delphi. I have seen 10 and 12 to one elsewhere, never 30. The recovery rate quoted was between 36% and 40%.

  3. TallIndian

    The Economist article ignores several problems:

    1) CDS are more akin to equity options than interest rate options and thus require equity like margins — 50% or more. Even if they wanted to, do the dealers even have that kind of cash lying around?

    2) How are the dealers going to capitalize the Clearing Corp? Buy insurance from AMBAC?

    3)In a clearing house, the dealers become jointy ressponsible if one dealer defaults and the clearing house needs more capital. If anything, a clearing house exacerbates the counterparty exposure problem.

    4) Cash settlement is no panacea — how do you determine the ‘cash’ price at the time of default?

    5) For most exchange-traded products, end of day valuation is not a problem. The price of the underlying is visible (and most likely trades on an exchange.) Even for an illiquid stock, you can get the price of the stock, plug in some vol into a BS model and get the option price. For a CDS, where do you get the price of the underlying. The wonderful folks at MarkIt? What model do you use?

    Clearing interest rate derivatives works because the total exposure is a fraction of the notional exposure, ‘jump risk’ is minimal, the price of the underlying is visible, and the positions can be delta hedged. Credit default swaps have none of these benefits.

    That otherwise reasonable people keep believing that a clearing house is going to mitigate or even solve the problem of credit default swaps shows the extent to which regulators and bank management are divorced from reality.

  4. foesskewered

    More than a little confused here; the biggest question from me is how enforceable are the existing CDS; as in when the organisation can’t pay its debt/goes belly up, how effective have they been /are going to be vs the notional/purported effectiveness? If the recovery rate is dismal, how would the clearing house help – unless they are planning for it to act like the FED’s free-for-all buffet.

  5. aid4families

    Economist have two flawed principles. One of course is the need to seem practical and not seem alarmist so everything is conservative, even if the facts don’t support it. The other problem I noticed is that they tend to look back to speculate or use sterile measures that don’t always accurately mimic all the intangibles. Economist said this would be over by labor day ’07, economist said that christmas would put liquidity into circulation but this slide has at least another 5 years to start forecasting any recovery and this cdo situation is just another example of the double speak.
    is where I talk in detail. Most people have no idea how the settlement of most of these financial instruments work, so when they hear the values stagnate they can’t make sense of it all. The biggest issue for establishing value for these things right now is the falling dollar. Add that to your equation and watch it ripple.

  6. Anonymous

    Every day I read another snippet of information and think to myself, I can’t possibly get any more freaked out than I am by what I just read. And voila! Along comes a new piece of information, and I realize I have not yet reached anywhere close to the proverbial prosperity corner.

    Thank you for today’s snippet that guarantees we are still miles from turning whatever corner it is that people still foolishly hope is out there.

  7. mickslam

    I have to disagree with the non-beneficial nature of the clearing house. Yes the margins are going to be far, far higher than they are now. Yes the price transparency is going to suck the profits out of the system.

    But the end of day prices are going to be transparent finally. There is going to be submission of suggested prices, and the clearing corp or exchange mechanism can set the price to where it wants. IF the dealers for these products want a different price, they are going to have to make a very valid case for this price. Remember, what CDS are is a summation of all of a firms corporate debt into one instrument. They should trade like stock. They should be margined like corporate bonds. As a result, getting closing prices isn’t a huge deal. Note that the best part about this is it will move things to level I assets from level III.

    Additionally, unconfirmed trades at 13% is probably a low-ball joke I’ve heard that there is years of back log in the backoffice for CDS. I’ve heard that it is not uncommon for trades to expire before they are confirmed. And the confirmation process is a joke in itself. Credit derivatives were the red-headed stepchild of the derivatives world and thats where the firms put the guys who couldn’t handle equity derivatives. Then CDS happened and these people simply were not able to handle the explosion of product.

    With all the financial industry has done to create chaos, there can be no doubt these products are going to be cleared.

    The Clearing corp was just re-capitalized by the Markit consortium banks. I think the press release was back in December. While the process is slow, clearing CDS is going to happen, and it is going to happen at the clearing corporation.

    I disagree about the default risk increasing with a clearing organization. The owners of the clearing corp have agreed to fund any losses that might occur. Plus, the CCorp already has incredible access to these firms account. To be a member, you have to have a bank account with substantial funds in place that the CCorp can draw whenever they would like. Their risk controls for this type of situation are quite good and far better than some IB or BD with an uncertain method of funding losses. While not perfect, its far superior to the current situation. Also note that systemic risk is monitorable with a clearing organization. You know the entire value of the market if you know the CCorps gross position, and going to individual clearing members, you can see their individual risk internally extremely easily.

    The offsetting will happen because the contracts will be standardized to some extent. The current mess is probably unfixable, but the future trades will have enough standardization that netting will not be an issue. Cash settlement will have to occur, due to factors like the Delphi issue you raised.

  8. TallIndian

    The owners of the clearing corp have agreed to fund any losses that might occur

    My point exactly. How does this reduce the risk to the system?

    Member A can’t meet a margin call, so Members B thru Z absorb this loss.

    This is some kind of solution?

  9. Aaron Krowne

    Two things:

    1. mickslam is right about the viability of a clearing house for CDS: while it might seem a stretch given the current state of the market, the whole point is to bring sanity to that market, which will result in a dramatically different situation while still providing the product under reasonable terms and conditions.

    2. Another approach to solving the problem (perhaps as an alternative to a dedicated exchange) would be to treat CDS as what it is: insurance (in the regulatory sense).

    Soros has now picked up on this idea (and I don’t necessarily endorse everything he says).

  10. Knute Rife

    The problem with CDSs is that they’re insurance policies that are treated like securities. Consequently, not only are they not priced anyway near to accurately in fact, there is no way they can be. How do you write an actuarial table for, say, a portfolio of short positions over unknown iterations, each with an unknown discount and commission structure?

  11. mickslam

    My point exactly. How does this reduce the risk to the system?

    Member A can’t meet a margin call, so Members B thru Z absorb this loss.

    This is some kind of solution?

    Yes, it is. The people that make the money have to cover for the person that can’t cover their losses.

    Plus, I am guessing the margining is going to be dramatically different. I know the Clearing orgs take their institutional integrity very seriously, from direct conversations with them. It is really their core business.

  12. TallIndian


    perhaps, i’m missing something. Right now, Bank A has exposure to Banks B thru Z on various CDS. If Bank A defaults, Banks B through Z have to eat this loss.

    Under the CCorp scenario, Banks A through Z now become Members A through Z.

    Member A defaults, and Members B through Z have to eat this loss.

    True, Member B-Z will also get any collateral posted by Member A as margin.

    I just don’t see C or LEH as having the capital to post signifcant margin and also be on the hook if GS runs into problems.

    Whole thing sounds like a Basel II regulatory/accounting arbitrage to actually lower the capital they have to set aside for their current CDS books.

  13. Anonymous

    at this point, the chain reaction seems critical and it doesnt matter if their is a clearing house or not at this point to systemic “domino” risk.

    After the “massive default reset” a clearning house is an excellent idea to promote transparency, stability, accountability and responsibility.

  14. Anonymous

    Only a 2% exposure, only $1.24 Trillion, that is still a significant real loss and would have a major impact on markets worldwide.

  15. john c. halasz

    I think Yves already implied this, but one obvious source of the continuing expansion of the CDS market amidst the general credit crunch is the need to correct for badly mispriced prior contractual commitments. If you’d written a CDS at 50bp a year ago that’s now selling for 250bp, you’d want to get an new position somehow to hedge your loss exposure. In social psychology, such behavior is called “forward flight”, typical of overgrown adolescents, if not outright sociopaths.

  16. Anonymous


    I’ve been looking for an answer to this to no avail, would greatly appreciate one:

    In event of default, does the insurer have to pay total nominal amount of (oversubsribed) CDS, or only the total of outstanding defaulted underlying bonds of the company that went belly up?

    That kind of makes a big difference, don’t it?


  17. Anonymous

    There are exactly two solutions to prevent systemic failure caused by CDS, once defaults start ticking up:

    1) Merge all the parties so net worth of contracts is zero

    2) Announce one day that all CDS have to be rolled back at current market prices.

    Only 2) is feasible. I’m waiting..


  18. Anonymous

    or to put it in more acceptable terms: all CDS that don’t satisfy new regulation (e.g. collateralized at notional value), have to be rolled back at previous day market price.

    Got something better?


  19. mickslam


    You are correct in your thumbnail sketch on how clearing works, but you are missing important details that might help to sway your opinion.

    Clearing is going to provide three essential elements that are not inplace right now.

    1. Daily settlement
    2. 3rd party risk evaluation
    3. Consistent margins

    Also, they provide the protection that you are so skeptical of. If you are not familar with futures style clearing, then clearing CDS won’t make any sense to you. As far as I know, there have been no defaults on futures style clearing in the U.S.

    The interaction between daily prices, proper margining-access to account, and clearing members absorbing losses is crucial to understand. Most swaps only pass cash flows at set intervals, while clearing houses do it every day. This mitigates the losses, assuming that we are not looking at 1 day events. So, barring one day events, losses don’t pile up. they are paid out day by day.

    Additionally, the clearing houses can simply take money from accounts that are owned by the clearing firms. Yes, they just take money whenever they want to cover potential losses and realized losses.

    Plus, a futures style clearinghouse is a zero-sum game. Every loss has to have an equal winner.

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