Credit default swap

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A credit default swap (CDS) is a credit derivative contract between two counterparties.

The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

See also ***House derivatives 2009***, CDS clearing, CDS confirmation, CFTC, derivatives, derivatives concentration, Markit and regulatory harmonization



Early markets

Credit Default Swaps were invented in 1997 by a team working for JPMorgan Chase [1] [2][3]

They were designed to shift the risk of default to a third party, and were therefore less punitive in terms of regulatory capital. [4]

Credit default swaps became largely exempt from regulation by the SEC and the CFTC with the Commodity Futures Modernization Act of 2000, which was also responsible for the Enron loophole. President Clinton signed the bill into Public Law (106-554) on December 21, 2000.

As the market matured, CDSs came to be used less by banks seeking to hedge against default and more by investors wishing to bet for or against the likelihood that particular companies or portfolios would suffer financial difficulties as well as those seeking to profit from perceived mispricing; the rapid growth of index compared with single name CDS after 2003 reflected this change.

The market size for credit default swaps began to grow rapidly from 2003; by the end of 2007, the CDS market had a notional value of $45 trillion. But notional amount began to fall during 2008 as a result of dealer "portfolio compression" efforts, and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion. [5]

Market as of 2008

It is important to note that since default is a relatively rare occurrence (historically around 0.2% of investment grade companies will default in any one year[6], in most CDS contracts the only payments are the spread payments from buyer to seller. Thus, although the above figures for outstanding notionals sound very large, the net cashflows will generally only be a small fraction of this total.

CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur. However, there are a number of differences between CDS and insurance, for example:

  • the seller need not be a regulated entity;
  • the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements;
  • insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets;
  • in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;
  • Hedge accounting may not be available under US GAAP unless the requirements of FAS 133 are met; in practice this rarely happens;
  • The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.

In "Credit Default Swaps: A Brief Insurance Primer author Mark Garbowski said " insurance insofar as the buyer collects when an underlying security defaults ... unlike insurance, however, in that the buyer need not have an "insurable interest" in the underlying security.

New York Times business writer Gretchen Morgenson said, "If a default occurs, the party providing the credit protection - the seller - must make the buyer whole on the amount of insurance bought."

Karel Frielink writing in says[7] "If the fund manager acts as the protection seller under a CDS, there is some risk of breach of insurance regulations for the manager. ... There is no Netherlands Antilles case law or literature available which makes clear whether a CDS constitutes the ‘conducting of insurance business’ under Netherlands Antilles law. However, if certain requirements are met, credit derivatives will not qualify as an agreement of (non-life) insurance because such an arrangement would in those circumstances not contain all the elements necessary to qualify it as such.

By contrast, to purchase insurance the insured is generally expected to have an insurable interest such as owning a debt.

Regulatory concerns over CDS

The market for credit default swaps attracted considerable concern from regulators after a number of large scale incidents in 2008 , starting with the collapse of Bear Stearns. [8]

In the days and weeks leading up to Bear's collapse, the bank's CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital which eventually led to its forced sale to JPMorgan Chase in March. An alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear's collapse; i.e. investors saw that Bear was in trouble, and sought to hedge any naked exposure to the bank, or speculate on its collapse.

In September the bankruptcy of Lehman Brothers caused a total close to $400 Billion to become payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed hands was around $7.2 billion[9]

This difference is due to the process of 'netting'. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral so their losses and gains after big events will on the whole offset each other.

Also in September American International Group (AIG) required a federal bailout because it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses over $100 Billion. The CDS on Lehman were settled smoothly, as was largely the case for the other 11 credit events occurring in 2008 which triggered payouts.[10]

And while its arguable that other incidents would have been as bad or worse if less efficient instruments than CDS had been used for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risk involved in CDS transactions.

Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in 2008Q2. The black disc represents the 2008 public debt.

In 2008 there was no centralized exchange or clearing house for CDS transactions; they were all done over the counter (OTC). This led to recent calls for the market to open up in terms of transparency and regulation[11].

In November,2008 the DTCC, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total market[12], began releasing market data on the outstanding notional of CDS trades on a weekly basis.[13]

The data can be accessed on the DTCC's website here: [14]

The U.S. Securities and Exchange Commission granted an exemption for Intercontinental Exchange to begin guaranteeing credit-default swaps.

The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. Its larger competitor, CME Group Inc., hasn’t received an SEC exemption, and agency spokesman John Nester said he didn’t know when a decision would be made.

Market as of 2009

The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from concerns over the instrument's safety after the events of the previous year. According to Deutsche Bank managing director Athanassios Diplas "the industry pushed through 10 years worth of changes in just a few months".

By late 2008 processes had been introduced allowing CDSs which offset each other to be cancelled. Along with termination of contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion. [15]

U.S. and European regulators are developing separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, administered by International Swaps and Derivatives Association (ISDA). Two of the key changes are:

  1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face.
  1. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where its not clear what the payout should be.

Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York, stated "A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. ... trading will be much easier, ... We'll see new players come to the market because they’ll like the idea of this being a better and more traded product. We also feel like over time we'll see the creation of different types of products."

In the US central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group.

Details for a European clearing are still being hammered out.

CDS description

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay).

Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded.

Credit Default Swaps can be bought by any (relatively sophisticated) investor; it is not necessary for the buyer to own the underlying credit instrument.[16]

As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor will make regular payments to AAA-Bank, and if Risky Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-off payment from AAA-Bank and the CDS contract is terminated.

If the investor actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing Risky Corp debt, without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky.

If the reference entity (Risky Corp) defaults, one of two things can happen:

  • Either the investor delivers a defaulted asset to AAA-Bank for a payment of the par value.

This is known as physical settlement.

  • Or AAA-Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if Risky Corp defaults, there is usually some recovery; i.e., not all your money will be lost.) This is known as cash settlement.

The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or Risky Corp defaults.

All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can impact the comparison.


Like most financial derivatives, credit default swaps can be used by investors for speculation, hedging and arbitrage.

For further information please see this link to Wikipedia. And here also: credit derivative.

CDS clearing

For further information on CDS clearing.

Source: Markit Credit-Swap Services Said to Be Part of Antitrust Probe Aug. 3, 2009, Bloomberg

Markit Group Ltd., the data provider majority-owned by Wall Street’s largest banks, is under Justice Department scrutiny for potential anticompetitive practices ranging from requiring customers to buy bundled services to restricting which trades can be cleared in the $26 trillion credit-default swap market.

Markit told a swaps clearinghouse customer to purchase a pricing service as a condition for granting use of its benchmark indexes, said a person with knowledge of the transactions. Markit permitted use of its indexes by another clearinghouse only if every swap guaranteed by the company included a dealer, such as one of its owners, said other people familiar with those negotiations."

Pricing and valuation

See current pricing and volumes for index and single name CDS, Aug 14, 2009)

Pricing systems

When the underlying "insured" cash bond defaults then the value of the payments to all the CDS holders is "fixed" through a process. You can see how this process happens here at CreditFixings. This site is the official resource to source cash settlement values for credit derivative trades subject to ISDA settlement protocols.

The following banks are called "contributing banks" in this process:

  • Bank of America
  • Barclays
  • BNP Paribas
  • Citigroup
  • Commerzbank
  • Credit Suisse
  • Deutsche Bank
  • Dresdner
  • Goldman Sachs
  • HSBC
  • JPMorgan
  • Merrill Lynch
  • Morgan Stanley
  • RBS
  • Société Générale
  • UBS

Theoretical pricing models

There are two competing theories usually advanced for the pricing of credit default swaps.

The first, which for convenience we will refer to as the 'probability model', takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by John Hull and White, uses a no-arbitrage approach.

For complete information on pricing and valuation please see Wikipedia here.

DTCC releases more CDS historical data

The Depository Trust & Clearing Corporation (DTCC) today further expanded its public release of credit default swap (CDS) data, providing more detailed market segmentation information on the largest corporate and sovereign CDS (single named reference entities) registered in its Trade Information Warehouse's (Warehouse) global repository. This extension of the data posted on DTCC's website ( will enable the public to assess key characteristics of these CDS contracts more efficiently and is another step in DTCC's on-going efforts to bring greater transparency into the over-the-counter (OTC) derivatives market. Starting today, DTCC is including specific additional information to that already shown in tables 6 and 14 for the top 1000 single reference entities posted on its website. This new information will cover the type of market (e.g., corporate, government), sector (e.g., financial services, sovereign) and the ISDA (International Swaps and Derivatives Association) Determinations Committee Region (e.g., Americas, Europe, Japan, Asia Ex-Japan, and Australia NZ) for each single named reference entity.

DTCC will also be posting a new table showing traded activity on a weekly basis initially for the top 1000 single-named reference entities. Being published in a new Section 4, this table is an extension of a report released last June and can be used to understand contract liquidity better. Similar to the data issued in June, the table will show traded activity levels and exclude certain contractual booking events (e.g. rebooking for clearing, and portfolio compression) which are not representative of price-making activity. Further enhancements will continue to be made to enrich the data for asset types, such as indices and tranches.

"We have seen considerable interest among market observers in getting a better view on the types of contracts and sectors that make up the largest portions of the CDS market, and see continued interest in volume levels," said Stewart Macbeth, general manager, DTCC Trade Information Warehouse. "Adding these specific classifications to the gross and net notional values and number of CDS contracts already published for these single reference entities will enhance the ability of the market to assess these contracts as part of a sector group or region. Providing additional traded volume information will build on the one-off report published in June, originally designed to give regulators more liquidity information, as they look at clearing."

Unfettered access to global regulators

Upon request, DTCC also provides global regulators with specific counterparty information needed to fulfill their regulatory mission. DTCC currently provides regular reporting to more than 30 regulators across the globe, including the Federal Reserve Bank, the Securities and Exchange Commission (SEC), the Commodities & Futures Trading Commission (CFTC), the European Central Bank, Banque De France, the U.K. Financial Services Authority (FSA), Bank of Japan and the Hong Kong Securities and Futures Commission.

It is one of DTCC's bedrock principles that all interested regulators should have unfettered access to Warehouse information to help further their respective regulatory missions. DTCC has also called for comparable access to data for regulators interested in specific trading patterns regardless of location. The standards for release of CDS data maintained in the US to non-US regulators would be the same as those for release to US regulators.

Since launching the Warehouse in 2006, DTCC has worked closely with market participants and in consultation with regulators across the globe to build a robust central repository that provides an accurate snapshot of the CDS market from a central vantage point. DTCC has also been collaborating with the OTC Derivatives Regulatory Forum, which is made up of more than 40 international financial regulators, to meet their objective of fostering a global framework for the sharing of data requested by regulators from the Warehouse. The Forum recently provided DTTC with new guidelines on the sharing of CDS data from its global CDS trade repository, helping bring greater clarity and building consensus on the process for responding to regulatory requests.

Earlier this month DTCC announced its plans to establish a new European subsidiary, DTCC Derivatives Repository Ltd., which will maintain global CDS identical to that maintained in its New York-based Trade Information Warehouse. Headquartered in London under a regulatory application filed with the Financial Services Authority (FSA), the new subsidiary is intended to help ensure that regulators globally have secure and unfettered access to global CDS data on (CDS) by establishing identical data sets on two different continents.

DTCC Derivatives Repository Ltd. will jointly house the global equity derivatives repository being built by DTCC as the result of winning the International Swaps and Derivatives Association (ISDA®) global bid for this service. The location of this European subsidiary was made based on the ISDA mandate to have the global equity derivatives repository in London.

About the Warehouse

The Warehouse is the only comprehensive global repository for the OTC credit derivatives market. DTCC uses it to gather and store information on OTC credit derivatives and perform critical post-trade processing functions such as automated calculation, netting and central settlement of payment obligations, as well as settlement of credit events such as bankruptcies. It is operated through DTCC's Warehouse Trust Company LLC subsidiary, which is regulated by the New York State Banking Department and a member of the Federal Reserve System. Its customer base includes all major dealers and more than 1800 buy-side firms and market participants in more than 50 countries.

The Warehouse publishes current and historical data on CDS trades. The data population includes all electronically confirmed contracts for both cleared and uncleared transactions. Currently, there are four active central counterparties (CCPs) utilizing the Warehouse services. While the Warehouse also has basic, non-legal records of highly customized trades ("copper records"), that data is not included in its weekly updates. These "copper" records, comprising more bespoke contract submissions not confirmable on an automated electronic platform, represent less than 6% of total contract volume held in the repository.

The total gross notional value of the nearly 2.3 million legally confirmed CDS contracts held in DTCC's Warehouse as of July 16 was approximately US$24.9 trillion.

DTCC updates its website weekly on Tuesdays, after 5:00 p.m. ET (2200 GMT).

The DTCC has published what it calls a “snapshot” of the CDS market, but it’s actually more like a “time-lapse movie” in that we now have nine months of data covering just about every single-entity CDS traded since June last year – sovereigns as well as corporate.

It’s a bald effort at convincing regulators and politicians that they’re talking through their respective hats if they think CDS are a natural for exchange-traded treatment. (Also, you can argue with the numbers, since the DTCC has stripped out “non-market risk” trades, therefore substantially reducing the visible size of the overall market.)

But hey, fascinating data nonetheless…

Here’s the DTCC blurb and a press release.

Here’s the actual data.

CDS pricing systems

"Markit is a leading provider of data and pricing products and services that are used globally by key financial institutions, including central banks, to monitor the markets, input into models and ensure stability across asset classes. CDS spreads are used to monitor weakness in the economy and ABS pricing for the risk management of financial instruments.

Used by more than 300 firms for mark-to-market, Markit is the benchmark for CDS pricing data, providing CDS composite and contributor level data on approximately 3,000 individual entities.

Product summary:

Markit receives contributed CDS data from market makers from their official books and records.

This data then undergoes a rigorous cleaning process where we test for stale, flat curves, outliers and inconsistent data. If a contribution fails any one of these tests, we discard it. By insisting on the highest standards, we ensure superior data quality for an accurate mark-to-market and market surveillance.

The full term structure of CDS data and recovery rates are available by entity, tier, currency and restructuring clause. Clients can view the data in summary or graphical form online. Alternatively, clients can retrieve the data through an automated feed or by a data download from Markit's website.

As an additional service, Markit Sameday provides a premium data service enabling subscribers to benefit from same-day CDS pricing captured from regional closes. Finally, we offer Markit Quotes. Markit Quotes is a real-time quote parsing service that extracts real-time prices, such as CDS and indices, from dealer pricing runs which are sent out to investors throughout the trading day.

Key benefits:

  • Independent pricing valued by investors
  • Rigorous data cleaning to ensure only the highest quality data is used in forming composite prices
  • Data available at tier, maturity, currency and doc clause levels
  • Wide breadth and depth of coverage
  • The industry’s richest historical data, going back as far as 2001

Flexible access to data via multiple delivery channels, including, Markit Desktop and automated download

Key functions:

  • Complemented by Markit Sameday for regional snapshots updated 4 times a day
  • Seamless integration with the industry standard CDS identifier Markit RED
  • Incorporates standard Industry Classification Benchmark (ICB) sectors
  • Integration with Markit iTraxx and Markit CDX index prices
  • Direct access to Markit analysts for price challenges
  • Ability to integrate data into internal systems or third party solutions

Naked CDS

There is ongoing debate concerning the possibility of limiting so-called "naked" CDSs. A naked CDS is one where the buyer has no risk exposure to the underlying entity; hence naked CDSs do not hedge risk per se, but are mere speculative bets that actually create risk. Some suggest that buyers be required to have a "stake," or element of risk exposure, in the underlying entity that the CDS pays out on.[17]

Others suggest that a mere partial stake in the underlying risk is insufficient, and would insist that buyer protection be limited to insurable risk; that is, the actual value of the capital-at-risk in the underlying entity.

This means the CDS buyer would have to own the bond or loan that triggers a pay out on default. Still others, also calling for the outright ban of naked CDSs, cite logic similar to that which prevailed in the call to ban markets for "terroristic events;" - namely, that it is poor public policy to provide financial incentive to one party which pay offs only when some other party suffers a loss - the argument being that it is foolish to incentivize the first party to nefariously intervene in the affairs of the second party so as to cause, or to contribute to cause, the second party loss event which has been speculated upon by the first party; such action, should it occur, is called "fomenting the loss".

Regardless of the intention of the buyers and sellers of "naked" contracts, it is the absence of ownership risk that is determinate.

Tax treatment

The U.S federal income tax treatment of credit default swaps is uncertain. (Nirenberg, David Z. & Steven L. Kopp. “Credit Derivatives: Tax Treatment of Total Return Swaps, Default Swaps, and Credit-Linked Notes,” Journal of Taxation, Aug. 1997: 1. Peaslee, James M. & David Z. Nirenberg). (Federal Income Taxation of Securitization Transactions: Cumulative Supplement No. 7, November 26, 2007, [18] (Ari J. Brandes. A Better Way to Understand Credit Default Swaps. Tax Notes (July 21, 2008). Earlier version of paper available at: [19]).

Commentators generally believe that, depending on how they are drafted, they are either notional principal contracts or options for tax purposes, (Peaslee & Nirenberg, 129) but this is not certain.

There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).(Nirenberg & Kopp, 8)

If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income.(Id.) If a payment is a termination payment, its tax treatment is even more uncertain.(Id.)

In 2004, the Internal Revenue Service announced that it was studying the characterization of credit default swaps in response to taxpayer confusion,(Peaslee & Nirenberg, 89.) but it has not yet issued any guidance on their characterization.

A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States. (Department of the Treasury, Internal Revenue Service, at the IRS website. “2007 Instructions for Form 1042-S: Foreign Person’s U.S. Source Income Subject to Withholding,” [20] (@4).

Hedging counterparty risk with CDS

"...Eighty-four percent of fund managers polled said they do not actively hedge counterparty risk through the use of derivatives. Managers said that doing so is more complex and costly than managing the risk through other means. More specifically, the cost of hedging through derivatives is likely to become an increasing concern during periods of market dislocation, as was seen during the crisis when credit default swap spreads on banks widened to historic levels.

“We look at the cost of CDS protection relative to the amount that needs to be protected, but it is often too expensive,” says Sid Kaul, head of risk at Cairn Capital. “Generally we would look to use equity options as an alternative to CDS as they can be cheaper and more liquid. Also we have seen CDS on financials widen dramatically during the troubled times of the past year.” Active hedging is “currently deemed too complex and expensive” says another respondent. Concerns were also raised by several asset managers about the suitability of CDS – which tend to be of a minimum two-year tenor – in hedging the short-term risks many investors face.

Meanwhile, the technical challenges of active hedging are another concern. “Hedging would involve taking daily P&L levels and trading jump-to-defaults on that,” says one trader at an asset management firm. But the amounts to be hedged (less than £500,000 in this case) would be too small to justify hedging using jump-to-defaults, he adds.

Those that do hedge counterparty risk through CDS tend to do so on an infrequent basis or as a last resort. “There is no systematic counterparty hedging process,” says Benoist Grasset, investment risk manager at Axa Investment Managers in France. “We view specific counterparty risk hedging as a last resort when other risk management measures are not possible or do not cover counterparty risk exposure efficiently.”

SEC begins CDS insider trading trial

Originally posted in the Times Online.

An insider trading trial could dramatically expand the powers of America's securities regulator to monitor the derivatives blamed for exacerbating the financial crisis.

The Securities and Exchange Commission will bring its first prosecution tomorrow for insider trading which involved credit default swaps (CDS). Attorneys described the prosecution as an attempt by the commission to assert its authority over CDSs at a time when Congress is discussing how to regulate the huge derivatives market.

Stanley Keller, a partner at the law firm Edwards Angell Palmer & Dodge, said: “It’s a very interesting and important case because it really covers the whole issue of the scope of the SEC’s enforcement authority.”

The commission has accused Jon-Paul Rorech, a bond and credit default swap salesman at Deutsche Bank, of giving Renato Negrin, a portfolio manager at the hedge fund manager Millennium Partners, inside information on an upcoming bond issue by VNU, the Dutch media company. They allege that the information handed Mr Negrin’s fund a €950,000 profit.

The regulator argues that in July 2006 Mr Rorech, whose employer was advising on the debt issuance, told Mr Negrin that VNU planned to issue bonds and suggested that he buy credit default swaps against the risk of a VNU default.

Credit default swaps are a type of insurance against a company defaulting on a security but are also used by investors to bet on the possibility of a default without owning the underlying securities. When a default occurs the CDS owners must deliver the security, such as a bond, to the seller in return for a payout.

At the time there was a shortage of VNU bonds that could be used by owners of VNU swaps in case a default occurred. With more bonds in the market the demand for swaps would rise. The issuance of new bonds by VNU would also increase its likelihood of default, increasing the value of the existing credit default swaps.

The commission cites a recorded telephone conversation in which Mr Rorech told Mr Negrin that the odds were “very good” that there would be a bond issuance by VNU. Mr Negrin asked Mr Rorech to give him some way to assess how likely the issuance was. The bond salesman allegedly replied: “You’re listening to my silence, right?” After their conversation Mr Negrin bought €20 million worth of VNU credit default swaps for his fund, making a €950,000 profit when the VNU bond issuance was announced.

The commission brought its case against the men last May, demanding that they give up their profits and pay a civil penalty. The regulator argues that credit default swaps qualify as securities-based swap agreements and therefore come under its jurisdiction.

Attorneys for Mr Rorech and Mr Negrin argue that the terms of credit default swaps are not based on the “price, yield, value or volatility” of a security but on a more remote event affecting the security, such as the company’s default, and are therefore not in the commission's remit.

Both men have denied any wrongdoing.

Dealer efforts to improve the CDS trade cycle

Source: New York Fed Commitment Summary Table July 31, 2008

This document summarizes the commitments to improve management of OTC derivatives activities that market participants are making to regulators as of July 31, 2008.

Since their collective effort to address weaknesses in the OTC derivatives market began in 2005, major dealers have reduced OTC credit derivatives (CDS) confirmation backlogs by roughly 93% and increased the percentage of trades that are confirmed electronically from 53% to more than 90%. During this time period, CDS trade volumes have risen by more than 200%.

On average, dealers have reduced their respective OTC equity derivatives backlogs by 70% from levels in mid-2006 and 95% of interdealer trades are now processed on electronic platforms.

The commitments below expand market efforts beyond OTC credit and equity derivatives to OTC interest rate, commodities and foreign exchange derivatives. They are centered on a near-term approach of escalating targets for reducing confirmation backlogs and greater use of electronic trade matching.

In parallel, market participants are developing a longer-term strategy for moving OTC derivatives processing to automated matching on trade date (T+0), an environment that will mirror performance in mature markets and eliminate material confirmation backlogs.

In addition to these operational improvements, major dealers are undertaking other steps to improve how they manage risks associated with OTC derivatives activities. These steps include:

  • The formation and use of a central counterparty for index CDS trades by December 31, 2008 that will comply with international regulatory standards for robust risk management,
  • Significant reductions in the total value of outstanding CDS trades through more aggressive use of multilateral trade terminations which will reduce operational risks and counterparty credit exposures,
  • “Hardwiring” an auction-based settlement mechanism into CDS documentation by December 31, 2008 in order to increase the certainty of a transparent and orderly settlement process following a credit event, and
  • Improving collateral management practices by reconciling portfolios on a weekly basis, committing sufficient resources to address any portfolio differences on a timely basis and reporting performance metrics regularly to supervisors.

CDS confirmation


As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash settled'.

  • Physical settlement: The protection seller pays the buyer par value, and in return takes delivery of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. In the event of a default, the bank will pay the hedge fund $5 million cash, and the hedge fund must deliver $5 million face value of senior debt of the company (typically bonds or loans, which will typically be worth very little given that the company is in default).
  • Cash settlement: The protection seller pays the buyer the difference between par value and the market price of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. This company has now defaulted, and its senior bonds are now trading at 25 (i.e. 25 cents on the dollar) since the market believes that senior bondholders will receive 25% of the money they are owed once the company is wound up. Therefore, the bank must pay the hedge fund $5 million * (100%-25%) = $3.75 million.

The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations. (This is because many parties made CDS contracts for speculative purposes, without actually owning any debt for which they wanted to insure against default.) For example, at the time it filed for bankruptcy on 14 September 2008, Lehman Brothers had approximately $155 billion of outstanding debt[21] but around $400 billion notional value of CDS contracts had been written which referenced this debt.[22]

Clearly not all of these contracts could be physically settled, since there was not enough outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for cash settled CDS trades. The trade confirmation produced when a CDS is traded will state whether the contract is to be physically or cash settled.


When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction (also known as a credit-fixing event) may be held to facilitate settlement of a large number of contracts at once, at a fixed cash settlement price. During the auction process participating dealers (e.g., the big investment banks) submit prices at which they would buy and sell the reference entity's debt obligations, as well as net requests for physical settlement against par. A second stage Dutch auction is held following the publication of the initial mid-point of the dealer markets and what is the net open interest to deliver or be delivered actual bonds or loans. The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled. According to the International Swaps and Derivatives Association (ISDA), who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman Brothers and Washington Mutual.[23]

Here is a link to Wikipedia for a list of the auctions that have been held since 2005 via Markit. Tradeable Credit Fixings.


Banks summoned by EU to discuss sovereign CDS market

Banks and regulators from across Europe have been summoned by the European Commission to discuss regulation of the market for sovereign credit default swaps in the wake of the Greek debt crisis.

The European Union agency will hold a meeting in Brussels “shortly,” Chantal Hughes, a spokeswoman for the commission, said in an e-mailed statement today. The meeting will be to learn about the CDS pricing mechanisms and links to the sovereign bond market and will take place as soon as March 5, according to three people familiar with the discussions.

Lawmakers are facing growing calls to regulate the products over concerns they are worsening Greece’s economic woes, which have pushed the euro lower. Greece tried to ward off speculators today by announcing an additional 4.8 billion euros ($6.6 billion) of budget cuts, after EU leaders called for greater austerity measures before considering aid.

The speed of the commission’s reaction is “surprising”, Karel Lannoo, chief executive of the Centre for European Policy Studies, said in a telephone interview today. “It’s only a week or so that the CDS story has been around,” he said.

Currency and bond speculators worldwide are under increasing regulatory scrutiny. Michel Barnier, the EU’s financial services commissioner, said yesterday that the EU would probe sovereign CDS trading. He said that the commission’s investigation “is not something we’re doing alone. The Americans are doing the same.”

Euro Bets

The U.S. Department of Justice is asking hedge funds not to destroy trading records on euro bets, sending the requests to managers who attended a dinner hosted by New York-based research and brokerage firm Monness, Crespi, Hardt & Co. on Feb. 8.

Adair Turner, head of the U.K.’s Financial Service Authority, questioned the usefulness of some CDS products, while testifying before a parliamentary committee.

“We are looking at the issue very closely,” Hughes said. “We need to be vigilant. We will be calling shortly a meeting of regulators, supervisors and the industry to discuss.”

The commission will meet with national financial supervisors on the morning of March 5 and CDS market participants in the afternoon, according to the people, who didn’t wish to be identified because the meetings are private.

Empty creditors and CDS

The use of credit default swaps is not systematically altering the bankruptcy process, according to a study commissioned by an industry group.

The report examined concerns about the so-called “empty creditor theory” which posits that creditors who have hedged their economic exposure to a company collapse are changing the nature of bankruptcies.

Credit default swaps allow bondholders to insure their investments against the danger of a particular company collapsing – but they only pay out in the event of a full collapse. A CDS pay-out is likely to see the bondholder recouping a higher proportion of their funds than is likely for an unhedged creditor.

Under the empty creditor hypothesis, bondholders who have bought CDS protection still have the same contractual rights as their unhedged peers, but have different economic incentives – and could even be inclined to let a company reach bankruptcy rather than help agree a work-out while it was still solvent. In the case of a bankruptcy, an empty creditor could undermine the reorganisation, especially if their hedged position and different incentives were not fully disclosed.

On Thursday the International Swaps and Derivatives Association said its study could not find evidence to back the assertions.

“The hypothesis is not consistent with the way CDS work or with observed behaviour in debt markets,” said David Mengle, head of research at ISDA. “Because it could influence future regulatory policy, it is important to analyse both the logic and the evidence in support of and against it.

The dangers of empty creditors have been highlighted by Henry Hu, a finance professor at Texas University who in September joined the US Securities and Exchange Commission as director of its new division of risk, strategy, and financial innovation.

On Thursday Mr Mengle said his study did not show that hedging led to systematic opportunities that could distort behaviour, and that this evidence would be needed before the issue should be treated by officials as a cause for concern.

Empty creditor supporters have warned that overhedged bondholders – those who have bought CDS worth more than their underlying bonds – could profit from a company collapse. However Mr Mengle said data could not be found to verify whether overhedging was a significant activity. He questioned, given the expense and low returns of the strategy, whether it was plausible

Calls for outright bans

Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency. Furthermore, there have even been claims that CDSs exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG.[24]

In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default.

It was also reported after Lehman's bankruptcy that the $400 billion notional of CDS protection which had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers (given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts could lead to further bankruptcies of firms without enough cash to settle their contracts.[25]

However, industry estimates after the auction suggested that net cashflows would only be in the region of $7 billion. This is because many parties held offsetting positions; for example if a bank writes CDS protection on a company it is likely to then enter an offsetting transaction by buying protection on the same company in order to hedge its risk. Furthermore, CDS deals are marked-to-market frequently.

This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, meaning that the net cashflows on the days after the auction are likely to have been even lower.

Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis, but that CDS contracts have been acting to distribute risk just as was intended, and that it is not CDSs themselves that need further regulation, but the parties who trade them. [26]

Some general criticism of financial derivatives is also relevant to credit derivatives.

Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's annual report to shareholders in 2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."[27]

It is true that entering a CDS transaction gives you counterparty risk, but bear in mind that it is also possible to hedge this risk by buying CDS protection on your counterparty! Furthermore, it is not strictly true to say that profit and loss is recorded without any money changing hands since positions are marked-to-market daily and collateral will pass from buyer to seller (or vice versa) to protect both parties against counterparty default. It is also worth noting that Buffett seems to have since changed his stance on derivatives since he made this statement, since in October 2008 Berkshire Hathaway was forced to reveal to regulators that it has entered into at least $4.85 billion in derivative transactions.[28]

In addition, Berkshire Hathaway was a large owner of Moody's stock during the period that it was one of two primary rating agencies for subprime CDOs, a form of mortgage security derivative dependant on the use of credit default swaps.

Systemic risk and CDS

The risk of counterparties defaulting has been amplified during the financial crisis, particularly because Lehman Brothers and AIG were counterparties in a very large number of CDS transactions. This is an example of systemic risk, risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.

For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds in 2005 and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After Lehman's default, this protection was no longer active, and Washington Mutual's sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. There was also fear that Lehman Brothers and AIG's inability to pay out on CDS contracts would lead to the unraveling of complex interlinked chain of CDS transactions between financial institutions.[29]

So far this does not appear to have happened, although some commentators have noted that because the total CDS exposure of a bank is not public knowledge, the fear that one could face large losses or possibly even default themselves was a contributing factor to the massive decrease in lending liquidity during September/October 2008.[30]

Chains of CDS transactions can arise from a practice known as "netting".[31]

Here, company B may buy a CDS from company A with a certain annual "premium", say 2%. If the condition of the reference company worsens, the risk premium will rise, so company B can sell a CDS to company C with a premium of say, 5%, and pocket the 3% difference. However, if the reference company defaults, company B might not have the assets on hand to make good on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to company C. The problem lies if one of the companies in the chain fails, creating a "domino effect" of losses.

For example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company. Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A; it is only doing business with company B.

As described above, the establishment of a central exchange or clearing house for CDS trades would help to solve the "domino effect" problem, since it would mean that all trades faced a central counterparty guaranteed by a consortium of dealers.

FSB will designate derivatives for central clearing

Original posted on Bloomberg by Ben Moshinsky and Joseph Heaven:

Financial Stability Board Chairman Mario Draghi said the global regulatory body plans to designate which over-the-counter derivatives should be standardized for central clearing “in the coming weeks.” This is “probably the most important part of our work,” he said at a debate at the European Parliament in Brussels today. Draghi also called for “fully harmonized trading platforms” for over-the-counter derivatives, otherwise “regulatory arbitrage” will be “instantaneous.”

Regulators are pushing for tighter regulation of the $605 trillion over-the-counter derivatives market, which includes credit-default swaps. More than 2,000 firms last year agreed to use standardized default swap contracts, making it easier to move them through central clearing houses that are designed to limit losses from default by a major counterparty.

Draghi said there are “very powerful vested interests that don’t want” central clearing of over-the-counter derivatives including credit-default swaps. “It is not an easy feat to centralize the trading of these derivatives.”

Responding to questions from EU lawmakers on the regulation of credit-default-swaps, Dominique Strauss-Kahn, head of the International Monetary Fund, said the sovereign swaps market “is not that big” compared with corporate swaps.

Barroso, Merkel

Jose Barroso, the European Commission’s president, said March 9 that the 27-nation bloc will consider banning “purely speculative naked” credit-default swaps after German Chancellor Angela Merkel and French President Nicolas Sarkozy called for a crackdown on derivatives trading to prevent a rerun of the Greek credit crisis.

Gary Gensler, chairman of the Commodity Futures Trading Commission, yesterday called on European lawmakers to coordinate efforts to monitor the over-the-counter derivatives market with the U.S. Regulators have been critical of so-called naked credit-default swap trading, where investors don’t hold the underlying bonds.

“The big challenge of a ban is to decide who is hedging and who is speculating,” Gensler said at the European Parliament in Brussels yesterday. “When is something naked? We know it in people but do we know it in CDS?”

The reforms to the credit-swaps market were part of an overhaul of the $25 trillion privately negotiated market demanded by regulators and policy makers including the Federal Reserve and European Commission.

Credit-default swaps are derivatives that pay the buyer face value if a borrower -- a country or a company -- defaults. In exchange, the swap seller gets the underlying securities or the cash equivalent. Traders in naked credit-default swaps buy insurance on bonds they don’t own.

IOSCO makes recommedations oversight of CDS

The final recommendations contained in the Final Report address issues of concern with respect to:

  • securitised products, including asset-backed securities (ABS), asset-backed commercial paper (ABCP) and structured credit products such as collateralised debt obligations (CDOs), synthetic CDOs, and collateralised loan obligations (CLOs); and
  • CDS (credit default swaps)

Credit Default Swaps

Final Recommendation 4 – Counterparty Risk and Lack of Transparency

IOSCO encourages industry responses in the CDS market and recommends the following regulatory responses:

  1. Provide sufficient regulatory structure, where relevant, for the establishment of CCPs to clear standardised CDS, including requirements to ensure:
  • a) appropriate financial resources and risk management practices to minimise risk of CCP failure;
  • b) CCPs make available transaction and market information that would inform the market and regulators; and
  • c) cooperation with regulators;
  1. Encourage financial institutions and market participants to work on standardising CDS contracts to facilitate CCP clearing;
  2. The CPSS-IOSCO Recommendations for Central Counterparties should be updated and take into account issues arising from the central clearing of CDS;
  3. Facilitate appropriate and timely disclosure of CDS data relating to price, volume and open-interest by market participants, electronic trading platforms, data providers and data warehouses;
  4. Support efforts to facilitate information sharing and regulatory cooperation between IOSCO members and other supervisory bodies in relation to CDS market information and regulation; and
  5. Encourage market participants' engagement in industry initiatives for operational efficiencies.

Final Recommendation 5 – Regulatory structure and oversight issues

IOSCO recommends that jurisdictions should assess the scope of their regulatory reach and consider which enhancements to regulatory powers are needed to support TC recommendation #4 in a manner promoting international coordination of regulation.

IOSCO believes that the recommendations relating to CDS might be used, or tailored, to inform general recommendations for other unregulated financial markets and products, in particular, standardised and non-standardised OTC derivative products where such products may pose systemic risks to international finance markets or could contribute to restoring investor confidence. Further work in this area, taking account of industry initiatives, may be necessary.

The Task Force was co-chaired by the Australian Securities and Investments Commission (ASIC) and the Autorité des Marchés Financiers (AMF) of France.

Stiglitz urges CDS trading ban for TBTF banks

" Large banks should be banned from trading derivatives including credit default swaps, said Joseph Stiglitz, the Nobel prize-winning economist.

The CDS positions held by the five largest banks posed “significant risk” to the financial system, Stiglitz said at a press conference in Brussels. Big banks should have extra restrictions placed on them, including a ban on derivative trading, because of the risk that they would need government money if they fail, he said in a speech today.

“We will have another armed robbery unless we prevent the banks, the banks that are too big to fail,” Stiglitz said. “We should say that if you’re too big to fail then you are too big to be. They need more restrictions, such as no derivative trading.”

Derivative trading and excessive risk-taking are blamed for helping to spark the worst financial crisis since World War II. American International Group Inc., once the world’s largest insurer, needed about $180 billion of government money after its derivative trades faltered and pushed the company toward bankruptcy.

Financial markets should be subject to taxes that will discourage “dysfunctional” trading and help pay for the effects that the global crisis had on poorer nations, Stiglitz said last week.

U.S. and European regulators have pushed for tighter regulation of the $592 trillion over-the-counter derivatives market, amid concerns that it could create systemic failures in the financial system. Lawmakers have called for global rules covering derivatives to prevent financial institutions from exploiting jurisdictional differences in regulation.

Former German finance minister Hans Eichel said in an interview today that global regulation would ultimately be needed. The European Union should enforce tougher legislation, even if the U.K. is reluctant to adopt stricter standards, he said.

“The Eurozone is strong enough economically to go it alone,” Eichel said. European legislation could then become the blueprint for global rules, said Eichel.


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