Sinclair on the power of ISDA

When is a default a default

FM: Have CDSs proven to be a fundamentally flawed product?

JS: Yes, but [they are] still out there to the tune of $700 trillion (meaning all OTC derivatives). The flaw is that they are specific performance contracts, unfunded. Unfunded specific performance contract is the definition of an OTC derivative. Now as an organization who rules $37 trillion worth of it and will decide if a credit event or a default has occurred, whether it is a CDS written on a major corporation listed on the New York Stock Exchange or whether it is written on Greek debt, according to the BIS the total amount outstanding is $37 trillion.

FM: How should they be regulated?

JS: How do you regulate what is already written? Now new ones can be put together with regulations with better definitions and could be cleared on an exchange. But in a crisis there has to be funding available to the writer to be able to perform on the contract. And nobody is proposing that they trade at 100% margin.

FM: Aren’t these binary products that should require 100% margin?

JS: It is impossible in the marketplace, and it would never be required on an exchange. If I make a contract with you to stand on my head in a clown suit if General Motors trades at $100, how are you going to regulate that? I am going to have to go out there in a clown suit. New ones could be written differently, older ones you could be stuck with. According to the Bank of International Settlements (BIS) the notional value of outstanding OTC derivatives was $1.144 quadrillion ($1,144,000,000,000,000) so they changed the method of valuation to values to maturity and took it from [that figure] to $700 trillion. This is the reason why QE must exist. Why the meltdown that was a product of the bankruptcy of Lehman Brothers and why the Treasury provided liquidity to the counterparties so that the derivatives could perform.

There is $37 trillion in [credit default swaps], both industrial and government issued. There is one body that will decide if any of those are called into performance. That body is the ISDA, that is the most powerful organization in the world. There are no rules. There may be rules defined by how a contract is written but there are no regulatory rules. The master agreement says the determination committee of the ISDA will determine if the event is a [default]. That is one hell of a powerful committee made up of the greatest names in finance.

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