Momentum Builds for CDS Oversight--But in What Form?

October 6, 2008
Shane Kite

Among other things, the amendment requires sellers of CDS to disclose the approximate term of the derivative; why the transaction was entered into; the status of the derivative's payment/performance risk, via external credit ratings or internal risk management groupings; and the maximum potential amount of future payments the seller could be required to make, or the reasons why that amount cannot be determined.

"Institutions that sell credit default swaps should be disclosing all kinds of information, which they don't have to disclose now," said an attorney who represents buy-side firms. Those clients have asked that her law firm not discuss CDS issues with the press. "Hedge funds are players, they don't disclose this stuff," she said. "The rest depends largely on self-reporting, so it's hard to get an accurate assessment of what the actual exposure is, and how much trading there is."

The attorney said buy-side clients began calling the firm early this year to complain about sometimes billion-dollar differences between the amount of collateral their counterparties were posting and their own calculations. "We started seeing disputes between our clients and their counterparties to the tune of $100 million, $500 million, $1 billion," she said. "If they don't pay up the collateral, they're in default of that payment obligation. That's grounds to terminate the entire relationship. So you're not just closing out two transactions, you're closing out 200 transactions. And you're netting them all to get a number that you either owe your counterparty or they owe you."

Accurate Valuations Tough

In a volatile, fragmented market that lacks real-time pricing, accurate valuations can be difficult. Tracking transactions and counterparties is also challenging, since CDS trades are typically done bilaterally and then often assigned to other firms.

"Institutions were for the first time finding out who their counterparties were and that these counterparties were unbelievably overburdened with exposures," the attorney said. "With an actual interest in an underlying bond or loan, you could sell that interest to someone. But you had people coming in who had no interest, and the total amount that's changing hands is huge. We've already written off more than the entire savings-and-loan crisis."

"The client demand and the regulatory demand for central trading venues and central clearing is growing demonstrably," said Richard McVey, CEO of New York-based bond-trading platform operator MarketAxess. "The amount of counterparty risk that is in the market today is considered to be way too high. Most participants in the market are looking for more efficient, liquid ways to not only trade but to clear the instruments. I think it is inevitable that there will be momentum building toward central electronic trading venues and central clearing for the CDS market."

"The U.S. hasn't really taken off in terms of electronic trading," said a source at a large interdealer broker. "We've had an oligopoly essentially run by the investment banks for quite some time, whereby they've wanted to keep a lot of the markets opaque and they've wanted to keep the brokers away from having screens." He added, "What's happened in the last few weeks could help a broker with a strong electronic offering."