Credit Default Swaps Outstanding Shrinks as Dealers Tear Up Agreements

The International Swaps and Derivatives Association reported that the notional amount of credit default swaps outstanding fell from $62 trillion to a bit under $55 trillion as dealers worked to eliminate offsetting trades.

This is a step forward, although it is hard to assess how significant it is. While the reduction in systemic risk is almost certain to be less than the fall in outstandings, eliminating offsetting contracts still eliminates possible points of failure. And if these offsetting contracts were not bi-lateral (ie between the same two dealers, which I would assume to be true in most cases), the net reduction is risk is greater. The fewer moving parts, the better.

Of course, this clean-up effort also comes as threats to regulate the market are getting louder. Nevertheless, a market like CDS is no stronger than its weakest link, which is this case is its shakiest large dealer. But how large you have to be to threaten the daisy chain is an unknown. Let’s hope we don’t get the answer via real-world experience.

Any comments from those with direct knowledge would be very much appreciated.

From Bloomberg:

The credit-default swap market, used to hedge against bond losses and speculate on corporate credit risk, shrank for the first time as efforts to eliminate duplicate trades cut contracts outstanding by 12 percent.

The volume of outstanding trades fell to $54.6 trillion from $62 trillion in the first half, the International Swaps and Derivatives Association said in a statement today. It was the first decline since ISDA started surveying traders in 2001.

“This decrease primarily reflects the industry’s efforts to reduce risk by tearing up economically offsetting transactions and demonstrates the industry’s ongoing commitment to reduce risk and enhance operational efficiency,” ISDA Chief Executive Officer Robert Pickel said in the statement. “We expect to see more effects of this over time.”…

The market has likely shrunk even more since ISDA’s poll after one of the 10 largest market-makers, Lehman Brothers Holdings Inc., filed for bankruptcy this month. ISDA’s survey captured trading as of June 30.

“I would expect that if they were to re-poll next week, you would see an even smaller number from netting activities and trade cancellations surrounding the Lehman Brothers default,” said Brian Yelvington, a strategist at CreditSights Inc. in New York.

After the March collapse of securities firm Bear Stearns Cos., 17 banks that handle about 90 percent of the trading in credit derivatives agreed to a list of initiatives to curb market risks. That included tearing up trades that offset each other, which cuts down on the day-to-day payments, paperwork and monitoring by bank staffs and reduces the potential for errors. It also may reduce the amount of capital that commercial banks are required to hold against the trades on their books.

The first stage of compression, completed Aug. 27, with the participation of 14 dealers, reduced contracts submitted on North American telecommunications companies by 56 percent, Markit Group Ltd. and Creditex Group Inc., which are processing the tear-ups, said this month. The second stage, completed Sept. 4, with 15 dealers, cut contracts on European telecommunications companies by 53 percent.\