From the May 01, 2009 issue of Futures Magazine • Subscribe!

Credit default swaps: Still the object of desire

“There is a growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient. ... Consequently, the commercial banks may be less vulnerable today to credit or economic shocks.”

– IMF Global Financial Stability Report, April 2006

At the start of the decade, clearing and settlement of over-the-counter (OTC) derivatives was being touted as the next big thing, and the London Clearing House’s “SwapClear” platform was seen as a glimpse into the near future of that.

Here we are, nearly 10 years later, and clearing and settlement of OTC derivatives remains the next big thing, while LCH.Clearnet’s “SwapClear” remains the tingly glimpse into the future it’s been for the past decade, even though it clears only plain vanilla interest rate and currency swaps.

Such trading accounts for 86% of OTC derivatives transactions, according to the Bank for International Settlements, but it isn’t nearly as lucrative as the more complex and risky credit default swaps (CDS) business, which accounts for just 11% of the OTC derivatives market.

As regulators in both Europe and the United States nudge broker-dealers into the clearing world, five clearinghouses have stepped up to compete for the business (See “Trader’s View of the World,” Futures, April 2009).

TABB Group senior analyst Kevin McPartland says that CDS clearing could become big business, generating revenues of $140 million per year by 2011, if just 55% of outstanding CDSs migrate to a central clearinghouse by then. That figure dwarfs the $27 million he believes can be earned by electronic platforms, if half of all CDS end up being executed electronically that year. It also shows why clearinghouses are scrambling to clear the business, while exchanges are lukewarm to offering trade-matching services.

Regulators, meanwhile, are beginning to wonder if the best way to deal with default risk is to minimize it, even if that means stifling a bit of innovation.


To understand the way regulators are responding to the global liquidity crisis, you need to see the issues that they are wrestling with as they navigate through the current crisis. No document provides better insight into that than the 126-page Turner Review, which was published by the UK’s Financial Services Authority in March and authored by FSA chairman Lord Adair Turner.

The Review walks through the current crisis and examines the thinking of regulators, policy-makers, bankers, and traders at every turn — beginning with the well-documented genesis of the current crisis in low interest rates and a hunger for return, which first drove investors to begin harvesting the private loan market and led them to behave like banks: holding long-term assets and sort-term liabilities.

Such “borrowing short to lend long” is what George Bailey did in “It’s a Wonderful Life.” It enabled him to make a living, and also to let Mr. Martini buy his house and pay it off slowly while still having access to short-term capital if he needed it.

In economic terms, that’s called “maturity transformation,” and it’s a bona fide social benefit that banks delivered in exchange for modest fees and a degree of protection from regulators. The price of that protection was regulatory oversight.

That bargain lost its currency over the past two decades, and the OTC derivatives sector became an argument for its demise, rushing in to offer that service as interest rates plunged.

The Turner Review questions some of the basic premises upon which the CDS sector is built and the alarms are not limited purely to the securitized mortgages that have imploded.

The report, for example, takes aim at the still-prevalent idea that you can abandon time-tested equity-to-assets ratios by applying sophisticated mathematical risk analyses to time frames of two to three years and believe they could really give you an accurate impression of “value at risk” (VAR). An almost palpable sense of anger creeps into the text as the Review recounts how several “risk managers” used a formula not much more sophisticated than “hair of dog and eye of newt.”

In retrospect, it’s clear that enshrining VAR as a premise of the syllogism of finance was the equivalent of taking a nifty trading system, back-testing it a few months, finding it works, and then declaring it not only valid beyond doubt, but mandatory for all practitioners.

But what’s most intriguing about the report is how every country developed its own unique way of catching the VAR bug, although nearly all buyers took on a strategy of “acquire and arbitrage”: first buy the stuff, then examine it, and finally hedge out the risks you’re uncomfortable with, while sellers became adept at packaging and pushing. Germany’s Landesbanken, ironically, came late to the game, and in the words of one dealer, “became the biggest buyers of the worst paper.”

Turner even dares to raise the question of whether securitization is inherently dangerous to the economy, or whether it’s only bad when it’s done wrong. He asks if the mortgage-backed bond debacle was a case of people securitizing the wrong batches of loans or whether the whole idea of securitizing loans destabilizes the economy because it leads to irrational swings in the prices of credit securities held by banks, which leaves their capital resources — the short-term liquidity upon which the rest of the economy depends — at risk.

He also takes apart the idea that the market will ultimately avoid risk if regulators just force those risks into the open, and points out that the market was aware of the potential for a bursting real estate bubble for years. Indeed, the subject was a top theme at pretty much every derivatives conference of the past few years.

Most damning of all, however, is his observation that the increase in the size of the wholesale financial services sector as a percentage of global GDP had surged until late last year as had profits from banks. That statistic flies in the face of arguments by bankers that they’re worth the bonuses they receive because they have helped generate efficiency for the market as a whole (at least if you accept the idea that efficiency means generating better results with fewer resources).

Factor in price of the systemic risk they generated, and it’s clear that efficiency is the last thing that the activities of large swathes of the financial sector contribute to the economy.


Turner concludes that “the future world of banking probably will and should be one of lower average return on equity but significantly lower risk to shareholders as well as to depositors,” and points out that banks are now two or three times as leveraged as are hedge funds.

The Review calls for ratcheting up capital and reporting requirements around the globe and abandoning compensation schemes that turn risk managers into bonus-blind speculators.

It also calls for tighter cooperation and information-sharing among regulators, and the creation of a new European institution to replace the Lamfalussy Committees that have tried to promote regulation by consensus among European regulators, and promoted a “passporting” system under which regulators kept an eye on their own.

A cornerstone of the European Union is the creation of cross-border banking but Mervyn King, Bank of England governor, pointed out that global banking institutions are global in life, but local in death, something Iceland and the UK learned when Landsbanki HF failed last October. Suddenly, London retail bank customers found that their deposits were ensured by an economy that wasn’t much larger than Björk’s record sales.

If passporting is abandoned, Turner believes a new pan-European entity should take its place, and this entity “should be … an independent authority with regulatory powers, (act as) a standard-setter and overseer in the area of supervision, and … be significantly involved in macro-prudential analysis.”

But here he diverges just a bit from his Continental counterparts. Germany’s regulator, BaFin, for example, has also been pushing for a central regulator but one located in the Eurozone and operating under the auspices of the European Central Bank.

Turner doesn’t address that suggestion, but the London Investment Banking Association and the Futures Industry Association have both issued statements critical of such a move. Turner merely stresses that regulators should focus on economic substance rather than legal form, and cautions the European Union to avoid the apparently unified but actually quite fragmented regulatory system that operates state-to-state in the shadow of the Securities and Exchange Commission in the United States.

He sides, however, with critics of regulation, who warn that some rules can be pro-cyclical, simply adding fuel to the fire by exaggerating destabilizing moves. He even concedes that marking positions to market could force an exaggerated correction on the downside, while conceding supporters’ contention that it would force overextended players to fess up.

Marking to market, he points out, also means that companies may appear to have more assets at the height of a move and that such traders and their bosses feel emboldened when times are good.

o, instead of just cautioning against pro-cyclical reactions, he recommends counter-cyclical solutions — and not just of the sort that the Obama administration is trying to implement by using government spending to compensate for the loss of private-sector consumption. Turner has proposed forcing banks to build up capital reserves in good times to be used in bad times, and keys us in to another debate sure to be all the rage if the idea takes hold: namely, how do you measure the amount that banks should hold in reserve in good years if you want to make sure they have enough on hand to loan out in bad years? Do you create a formula, or do you give regulators some discretion in making the determination?

More and more of the solutions flowing from these premises are aimed at taking the money that currently goes into traders’ pockets and putting it into capital reserves for companies that behave like banks. For example, a proposal for ‘dynamic provisioning’ would require the banks to allow for losses not yet there, and then put them on their books.

Ultimately, however, he seems to have come down on the side of less rather than more regulation, concluding that more research needs to be done before we know the full merits and drawbacks of on-balance-sheet loans plus securitization.

Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), has long insisted that the extravagant notional value of CDSs relative to the underlying value was wildly overstated, largely because participants tended to create offsetting positions rather than close out existing ones. Over the past few years, companies like Markit have come up with solutions that compress massive ganglia of trades into more manageable and transparent positions. This process is called “compression,” and it is just one of the reasons that Markit has been appointed as administrator of ISDA’s new open source project for modeling CDS business.

TABB’s McPartland says that compression — or the realization of previous liquidation, and not real-time liquidation itself — is largely responsible for bringing the outstanding notional value down from $62 trillion at the end of 2007 to $28 trillion (see “Complex margining”).


Not everyone sees a massive stampede to clear OTC CDSs, even at the prodding of regulators.

In the early phase, the only contracts that will be cleared are indexed products, such as the iTraxx indexes that Eurex launched futures on two years ago. McPartland doesn’t expect to see any single-company products cleared until very late this year, or more likely early next year.

He also points out that indexed products make up just 37% of the CDS market, according to the DTCC Trade Warehouse. Fully half the market is comprised of single-name swaps, which are more volatile than indexes.

Hill agrees that single-name clearing is a ways off, but says much of the tedious and controversial work, such as agreeing on what constitutes a credit event, has already been done. He believes the last 10 years are no indication of the speed with which product development will move from now on.

Not that long ago, swaps were agreed to by phone and confirmed by fax, with the Internet becoming acceptable in 2005. By then, it typically took two weeks to confirm a trade. Automated netting and counterparty assessment protocols paved the way for automated execution, and that brought the backlog down to less than five business days.

“In the mid-1990s, it took a week and an army to get a trade done so we did one a week,” Hill says. “Now, we’re not doing one a week, but thousands per day.” He says ISDA’s new protocols for cash-settling CDS will help create even more fungibility and thus more ease of clearing.

For now, exchanges are working with broker dealers to weave their systems into the DTCC warehouse and hunkering down with their onetime enemies and perpetual objects of desire.

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