Credit default swap dealers reduced the amount of outstanding contracts to $38.6 trillion last year as they tore up offsetting trades amid pressure from regulators to scale down the privately negotiated market and reduce risk.
Outstanding CDS contracts fell 38% by year-end 2008 from $62.2 trillion at year-end 2007, according to the International Swaps and Derivatives Association in a survey released at its annual general meeting in Beijing on 22 April. They fell 29% from mid-year 2008.
The decreases compared to prior-year periods underscore the success of the industry’s portfolio compression efforts, in which firms boil down millions of trades that cancel each other out without affecting their risk profiles.
Regulators have said they want dealers to significantly reduce their gross exposures to each other to help prevent a logistical mess if there is a large-scale default and dealers cannot quickly figure out who owes what to whom.
Credit default swaps are used to protect against a borrower defaulting on their debt or to speculate on their credit quality. The ISDA survey monitored CDS on single names and obligations, baskets and portfolios of credits and index trades. The $38.6 trillion notional amount was approximately evenly divided between bought and sold protection, the organisation says.
It is the first annual decline, after the market increased 100-fold in the previous seven years. The Depository Trust & Clearing Corp., which provides clearing, settlement and information services for OTC derivatives, puts the size of the market at $28.2 trillion.
After the collapse of Bear Stearns last year, 17 banks that handled about 90% of trading in CDS agreed to initiatives including the standardisation of trade processing and trade compression to help reduce day-to-day payments and potential for error (Squawkbox, 16 June, 2008).
“In the current environment, firms are intensely focused on shrinking their balance sheets and allocating capital most productively. They are also looking to increase operational efficiency,” says Robert Pickel, executive director and CEO, ISDA.
In the same vein, more than 2,000 banks, hedge funds and asset managers trading CDS earlier this month agreed to ISDA’s Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol, or ‘Big Bang Protocol’.
The protocol aims to improve transparency and confidence in CDS contracts. It will introduce more consistency into the CDS market by imposing a uniform procedure for settling CDS contracts when a company goes into default. It will also impose more standardisation by introducing set coupons for contracts, a measure that will initially be limited to the US, but could later spread into Europe.
The protocol aims to change the way the swaps are traded so that it is easier to move them through a clearinghouse, which is viewed as key to removing systemic risks posed by the failure of a large CDS counterparty.
Efforts are intensifying to put CDS trades through a centralised platform with the Intercontinental Exchange up and running with one clearing system in partnership with banking groups. CME Group is expected to announce a launch date for its US credit derivatives clearinghouse in the coming weeks.
In Europe, exchanges vying for business in CDS clearing are: NyseLiffe and LCH.Clearnet, Eurex Clearing, part of Deutsche Brse, and Intercontinental Exchange.
In addition, two Japanese clearing houses last week announced plans to introduce clearing for CDS and interest rate swaps next year. Japan Securities Clearing Corp. and the Tokyo Financial Exchange are working out details on infrastructure investment, fees and overseas co-operation after spending six months conducting separate study groups with domestic and overseas financial institutions.