Industry unites to cut systemic risks in CDS

The bankruptcy of Lehman Brothers stunned the global financial system, but it was well flagged in one corner of the markets.

In the credit derivatives markets – where dealers and investors buy and sell insurance against defaults – the costs of insuring against a Lehman bankruptcy had soared, indicating its likely collapse.

By Monday morning, September 15 2008, it was clear that banks, insurance companies and others who had sold such default insurance would have to make good on those promises.

Just at the time the investors who had bought some of the $150bn of Lehman Brothers debt realised that this was now essentially worthless, those insurers against a Lehman default were facing a huge bill.

The question was, how big a bill? There was no clear answer as to how much had to be paid out – the ambiguity being one of the consequences of the rapid-fire growth of the credit default swap (CDS) markets, worth over $60,000bn on paper but about which few sensible statistics were publicly available.

Market estimates of Lehman CDS contracts reached as high as $400bn. There was little idea as to who had to pay, and whether banks might crumble under the weight of those losses.

“When Lehman defaulted, you could not get an easy answer to the question of how much exposure there was in the CDS market,” said Bill Stenning, a managing director at the Depository Trust & Clearing Corporation, “Now, that kind of information is made public. That has been one of the big changes in the market in the last year.”

In the event, the face value of insurance written on Lehman’s credit was about $72bn, according to the DTCC, with no more than $6bn of net exposure, or the amount of money that actually changed hands once contracts that had been offset had been taken into account. All pay-outs were made.

Other measures have been taken to reduce the systemic risks in the CDS market. Banks have tried to cancel out contracts. Already, such “compression” has halved the amount of nominal risk outstanding in the CDS market. Other steps include the introduction of standard coupons and rules that set out a clear process in the event of a default.

“The resiliency the market has shown is surprising,” said Bradley Rogoff, credit strategist at Barclays Capital, adding that trading volumes and liquidity were still lower than they were a year ago.

The future scope of the credit derivatives market reform still remains unclear and is part of a broader debate about the over-the-counter derivatives market, which includes privately traded interest rate, foreign exchange, commodity and equity derivatives.

The collapse of Lehman also affected billions of dollars worth of derivatives contracts to which the bank was a counterparty. Among the thorny issues on the table is how much centralised clearing should be required for derivatives, and whether it should apply to all users, including companies, which say clearing could make derivatives costlier.

There are key tests ahead.

First of all is whether or not clearing can be extended to incorporate investors in the CDS market, as well as dealers. To instill the final level of confidence, clearing has to be made available to investors. Many investors took losses on positions they had to which Lehman was the counterparty,” said Mr Rogoff.

Second, is the shape of regulation. The US government has submitted a draft legislation to lawmakers, but the timing and final details remain murky.

Hanging over the industry too is the view – held by some big investors and regulators – that credit derivatives are merely gambling tools. As more companies enter into credit problems and potential defaults, regulators will be watching whether CDS holders, which may make money from a default, influence restructuring attempts. Regulators are also watching the extent to which trading in CDS can affect share prices.

Still unknown is whether the CDS market will emerge stronger as use escalates on the back of standardisation, or whether transparency and clearing costs will make it unprofitable.