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.”