Sunday, September 7, 2008

Credit Derivatives Operational and Settlement Risk

Operational risks have been cited as a possible source of disruption in credit default swap (CDS) markets, largely because of the rapid growth in outstanding contracts. These concerns had manifested themselves in the form of large backlogs of unconfirmed trades. However, banks and dealers, encouraged by the New York Fed and other authorities, have undertaking important infrastructure improvements.

Concerns had also been raised about settlement problems associated with defaults by entities for which the notional value of CDS contracts far exceeds the outstanding amount of underlying deliverable obligations. However, the new cash settlement protocol introduced by the International Swaps and Derivatives Association (ISDA) has successfully smoothed the settlement process in nine credit events since 2005.[1] Dealers have committed to incorporate this protocol into the standard documentation for widely traded credits.[2]

Nevertheless, there remains the potential for market disruption following the simultaneous failure of a major CDS protection seller and an actively traded reference entity, due to the large overhang of redundant bilateral contracts. Such offsetting contracts proliferate because, rather than closing out existing contracts, counterparties often arrange for offsetting contracts. The size of this overhang has been reduced during the last few years among banks and dealers by multilateral terminations (“tearups”) of offsetting contracts. TriOptima’s “TriReduce” service processed $10 trillion tearups in 2007 and $18 trillion in the first half of 2008. In addition, Creditex and Markit are planning to offer a “portfolio compression” service that, instead of tearing up offsetting contracts, replaces them with a smaller number of replacement contracts.

Also, in order to further mitigate these counterparty risks, the major credit derivative banks and dealers are banding together to create a central clearing house, but this will not be fully operational until late 2009 and other market participants (e.g., hedge funds) will not be included.[3] Under this scheme, bilateral contracts will be reassigned so that Chicago-based Clearing Corporation will become the new counterparty for both sides. For any given participant, all of its transactions on the same underlying entity will be netted down to a single position, and a single margin account maintained on its whole portfolio of swaps.[4]

It is also significant that about 90 percent of credit derivatives transactions are now being processed electronically. Although the degree of automated trade processing of other over-the-counter (OTC) derivatives lags that of credit derivatives, the major dealers have made commitments to the authorities to be electronically processing 75 percent of equity derivative trades and 65 percent of interest rate derivatives by January 2009.

However, despite all of these very positive developments, the default of a major CDS derivatives counterparty would likely be a market disruptive event, particularly if it were one of the ten investment banks that stand behind about 90 percent of outstanding contracts according to Fitch's latest survey. Even without a simultaneous failure of one of the more actively-traded underlying entities, the logistics of closing out trades with the failed counterparty would likely be challenging. All surviving counterparties would have to gather together all of their outstanding derivative trades (not just CDS trades) with the defaulting counterparty, and try to replace them with contracts with other counterparties, offset them, or close them out. This could be happening while spreads may be gapping out across the market, since other prospective counterparties are likely going through this same process.


[1] In a physical settlement, the protection buyer delivers obligations to the protection seller in exchange for par value. In a cash settlement, the protection seller pays out the difference between par value and the market value of a deliverable obligation. The new settlement protocol makes cash settlement the standard, but still allows anyone who wants to physically settle to do so, provided the final settlement price is not zero or par. See Bank of America's "Credit Default Swap Primer" (May 5, 2008) for a comprehensive discussion of operational risk issues in CDS markets.

[2] The current cash settlement protocol applies only to bankruptcy and failure-to-pay events, and not restructuring events. This could be problematic versus European and sovereign credits, where restructurings are more common.

[3] The clearing house is scheduled to start up by 2008Q4 with contracts based on standardized index-based credit derivative contracts, but single-name contracts will not come on stream until late 2009. Single-name contracts are hard to handle because they have different premia, although some dealers are pushing to standardize fixed premia.

[4] LIFFE will also be clearing contracts linked to the Markit  iTraxx indices by the end of 2008.