Don’t stir the pot if you don’t understand the ingredients

The prospect for bigger haircuts on Greek government bonds is in the news, and so too is speculation about the CDS market. With that speculation, unfortunately, comes inaccuracies. Once again we will try to set the record straight — this time regarding an opinion piece in the Wall Street Journal online edition by Athanasios Ladopoulos of Swiss Investment Managers.

The article cites a BIS report that “US creditors own just 5 percent of direct exposure to Greek debt. But they are indirectly exposed to at least 43 percent of such debt through CDSs, which total upwards of €25 billion.”

We honestly do not know where these numbers come from. There’s some US$485 billion of Greek debt outstanding. Five percent would be about US$25 billion. But 43 percent would be nearly US$210 billion!

Now compare this to the data at DTCC, which manages the CDS trade information warehouse that captures more than 98 percent of CDS trade volume. The Gross Notional exposure to Greek government bonds through CDS is $75 billion while the Net Notional exposure is a mere $3.7 billion. Which number to use? If Bank A writes protection on Greece for a client for, say, €25 million, and immediately buys protection from Bank B for the same €25 million, it will have Gross Notional exposure of €25 million and Net Notional exposure of zero. The Net Notional exposure of all the participants in the CDS market is $3.7 billion. This is not netted across participants. The longs are $3.7 billion and the shorts are $3.7 billion.

Perhaps Mr. Ladopoulos’ use of the word “indirect” refers to the credit risk creditors face if their counterparties default. Mr. Ladopoulos should then have referred to ISDA’s survey results and other literature. CDS counterparty risk is covered by collateral in almost all circumstances. Our most recent margin survey indicated that collateralization covered 93 percent of CDS transactions and the vast majority of collateral was cash.

We hate to see articles that are not completely researched “stir the pot.” there’s too much at stake for people to keep getting this wrong.

With Friends Like This….

It’s one thing to get criticized by those who don’t understand or like the financial markets. It’s another when the criticism comes from someone who does. A recent Forbes op/ed is clearly in the latter camp. It’s unfortunate and disappointing that it is based on an outdated, inaccurate view of the CDS market.

Contrary to the article’s assertions, CDS trading volumes are publicly available, via the DTCC Trade Information Warehouse. This and other trading information has been available for some time and levels of activity in the CDS market are no surprise to financial market professionals.

In addition, market participants have long maintained that CDS prices should be viewed in context. They are just one indication of credit risk. Would anyone – Mr. Forbes included – buy a stock based on one metric?

Collateral: The Rest of the Story

Recent media articles in two of our favorite publications (The New York Times, The Wall Street Journal) raise interesting points about an important derivatives risk management practice: collateralization of exposures. Both stories essentially question whether net derivatives exposure accurately captures the risks of a firm’s derivatives activity. They say that net exposure assumes (among other things) that collateral management is rigorous, and they wonder whether it really is.

Fair questions. But we wish the stories had gone one step further and sought answers to them by examining the data and the initiatives that exist or are underway in this area.

According to ISDA’s Margin Survey, 73% of OTC derivatives exposures are collateralized. The chart below shows that collateralization is highest for hedge fund exposures and lowest for governments and supranationals.

Collateralization levels by counterparty type

What do firms post as collateral? Cash represents around 81% of collateral received in 2010. Government securities constitute 10% percent and the rest is comprised mostly of corporate bonds, equities and government agency securities.

Looked at by product type, 93% of all credit derivatives trades executed by firms responding to the survey were subject to collateral arrangements during 2010. 70% of all OTC derivatives transactions were subject to collateral agreements during this period. This includes transactions with end-users and spot FX transactions, which due to the nature of these trade types, are not generally collateralized.

The 14 largest reporting firms, representing the world’s largest derivatives dealers, reported higher rates of collateralization. For this group, an average 96% of credit derivatives trades were subject to collateral arrangements during 2010. Overall, 80% of all OTC derivatives transaction executed by the large derivatives dealers were subject to collateral agreements.

The data confirm that collateralization is an important component in managing the derivatives exposures of market participants worldwide. That’s why ISDA and our members are engaged in a broad set of collateral-related initiatives — including research, documentation, best practices and practitioner guidelines.

We also believe it’s important for policymakers to have an accurate understanding of collateralization. That’s one reason why ISDA has called for the development of a single, global Counterparty Exposure Repository. This repository would provide an aggregated risk view for regulators of the net mark-to-market exposure for each counterparty portfolio, the corresponding collateral and the firms’ calculation of net exposure after the application of collateral.