“Shocked, shocked”

A paper on the CDS market released yesterday by the New York Fed drew some interesting reactions in the media.  With apologies to Claude Rains and Casablanca’s scriptwriters, some news outlets are “shocked, shocked” to find that most single-name CDS are thinly traded, and that CDS exposures are often not immediately hedged. We at ISDA are not, of course, as we did similar research some time ago. It’s one of the reasons most market participants have always believed that CDS prices and price movements are one – but only one – tool that indicates the level of and changes in credit risk.

Our research also informs our view regarding post-trade reporting requirements for OTC derivatives. Most media got this right: relatively thin trading means it is harder and takes longer for dealers to hedge their risks, and post-trade reporting requirements need to be structured appropriately.

Some, though, focused on the fact that the Fed paper also said that same-day reporting requirements won’t affect same-day hedging, because most dealers don’t hedge their risk immediately. In their view, this means same-day reporting is appropriate. We (and most others) take the opposite view.  Dealers need time to hedge their positions, and inappropriate post-trade reporting for larger and less liquid transactions is likely to harm liquidity and risk management.


“There you go again….”

Back in the 1980 presidential campaign, Ronald Reagan used this phrase to great effect to fend off criticism that was untrue or exaggerated. Today, it’s a phrase we think about saying often, particularly when it comes to news reports about the OCC’s Quarterly Report on Bank Trading and Derivatives Activities.

The 2011 second quarter edition is just out and, as usual, it’s creating some misperceptions that need to be clarified. The New York Times, for example, reported on it and said that “The nation’s four biggest banks… are the biggest players, holding roughly 95 percent of the industry’s total exposure to derivatives.”

As we’ve noted in the past, the OCC report only covers part of the US market. The data includes derivatives exposures of US dealers and US subsidiaries of non-US dealers. But it does not include exposures arising from transactions between a US firm and a non-US dealer.

Even more importantly, the OTC derivatives market is global, with competitors from all geographic sectors. On a global basis, the five largest US-based dealers held 37 percent of total derivatives notional according to an analysis ISDA did last year. The G14 group of dealers (the 14 largest) held 82 percent of total notionals outstanding.

The depth and breadth of competition in OTC derivatives is also supported by data from SwapClear, which requires members to have at least $1 trillion in notional outstanding. There are at last count 38 separate dealer/members who meet this criterion.

This leads us to ask: which other global markets have as many firms competing for business as this one?

Sunday NY Times – Neither Here Nor There

Press coverage of the European debt crisis and its potential impact on the US is a favorite topic of the media these days.  A case in point is “Suddenly, Over There Is Over Here,” a column in The New York Times Sunday Business section on September 18.

According to the column, there are two major risks facing US investors from the problems in Europe.  Only one concerns us here:  “…the potential for losses incurred by financial institutions that wrote credit insurance on European government debt and the European banks that own so much of that paper.”

How much could these losses total?  According to DTCC, and as the article notes, the net CDS exposure on Greece, Spain, Portugal and Ireland is $23.6 billion.  Does that mean that nearly $24 billion could change hands if ALL of these countries defaulted?  Well, no.  That’s because exposures are marked-to-market and roughly 90% of that market value is secured by collateral.  In addition, the amount the protection sellers pays to the protection buyers is further reduced by the recovery value of the bonds upon which protection was sold.  For sovereigns, that could be in the range of 40% to 50%.

So if we do the math, the actual cash payout on all the CDS on Greece, Spain, Portugal and Ireland would be less than $1 billion:

Net CDS notional on four sovereigns:               $23.6 billion

Less 90% collateralization of mark to market exposure
assuming MTM is 40% of par)                        13.6 billion
Less recovery value of bonds referenced by CDS
 (assuming recovery value is 40% of par)             9.4 billion
Total cash payout                                  $ 0.6 billion

This doesn’t mean, by the way, that the losses by CDS sellers would be less than $1 billion.  The actual losses incurred would be the amount of protection sold less the premiums received and the recovery value of the bonds on which protection was sold.   But it does mean that the actual cash paid out by institutions in the event of a loss is likely to be a very manageable number.

You can also apply this calculation to estimate what the payouts would be on financial institutions that deal in CDS.  The net notional outstanding on the world’s 10 largest financial institutions is about $37.5 billion. 

Now contrast the figures on sovereign CDS with the size of the government bond markets for the four sovereigns:

   Greece:     $   484 billion
   Spain:          896 billion  
   Portugal:       219 billion
   Ireland:        154 billion

   Total:      $ 1.753 trillion
(Data: Bloomberg, September 20, 2011)

Obviously, the CDS market is a tiny fraction of the size of the underlying sovereign debt market.

One additional point about the story requires clarification.  The article states that CDS “instruments trade in secret.”  The fact is:  a CDS trade repository that captures virtually all CDS trade activity is up and running (and has been for several years).  Some of this information is public (you can access it here).  More granular information is available to regulators.  As a result, transparency in the CDS market – as well as with other segments of the OTC derivatives markets – is significantly improved over the past few years.  In fact, Dodd-Frank and other regulations do not require providing additional public information on counterparty positions and exposures. 

Finally, the article states that “the huge market in credit default swaps remains unregulated and remains in the shadows.”  In light of the facts regarding trade repositories and with the passage of Dodd-Frank, we can only say:  “Really?”