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How the Credit Default Swaps Market Works

Regulators have stepped up calls since the collapse of Lehman Brothers last month for more supervision of the $55 trillion credit derivatives market to improve its safety and transparency.

Below are facts about the market to date.

How They Work: Credit default swaps (CDS) are over-the-counter contracts between two counterparties that bet on whether a company will default on its bonds within a fixed period of time.

In its simplest form, one side of a CDS contract pays an annual fee to buy protection against default. The other side, the seller of protection, promises to cover losses in the value of the debt if a default takes place within the period of the contract.

When the market began trading, if a default or other agreed "credit event" such as change of control occurred, the buyer of protection would hand the bond over to the seller in return for
its face value. Cash settlement is now a more common market option (see below).

Investors use CDS to hedge against cash investments or to speculate on the direction of the credit markets.

Market Size

  • end-2001: $918 billion
  • end-2002: $2.2 trillion
  • end-2003: $3.8 trillion
  • end-2004: $8.4 trillion
  • end-2005: $17.1 trillion
  • end-2006: $34.4 trillion
  • end-2007: $62.3 trillion
  • mid-2008: $54.6 trillion

Amount of outstanding contracts, according to the International Swaps and Derivatives Association (ISDA).

Market History

In the early 1990s dealers began to develop an organized market from ad hoc attempts by banks to hedge credit risks on their books.

In 1997, 1999 and 2003, ISDA issued agreements and definitions that helped standardize CDS contracts.

In 2004, indexes created by different investment banks merged to create the CDX series of indexes in North America and the iTraxx indexes in Europe, with Markit as the sole data administrator.

In spring 2005, the first auction was organized after a default to come up with a price for cash settlement of contracts, instead of requiring that the protection buyer deliver a physical bond.

In September 2005, the New York Federal Reserve Bank called 14 major dealers to a meeting on market operations after backlogs between trade and settlement became as long as 90 days.

This led to the creation of a central depository and an agreed protocol under which investors and dealers must request the approval of a counterparty to transfer the risk to a third party, known as novation. This enabled dealers to better determine risk exposures by netting out offsetting trades.

At end-July 2008 in a letter to the New York Fed, CDS dealers and industry organisations agreed on a set of goals to make market operations more efficient, including creation of a central clearing house.

In September 2008, Lehman Brothers was the first major dealer to file for bankruptcy, triggering billions of dollars of losses by its counterparties and by sellers of protection on its
debt.

Cash Settlement

Auctions for cash settlement of contracts have become standard practice, used to resolve around 13 credit events so far, according to the ISDA Web site. This has allowed the outstanding amounts of CDS contracts to expand to multiples of the number of outstanding cash bonds for the names that are most active.

The latest auctions in October covered the debts of Lehman Brothers and Fannie Mae and Freddie Mac.

Cash Settlement Auctions -- Forthcoming Dates

  • Oct. 23: Washington Mutual
  • Nov. 4: Landsbanki
  • Nov. 5: Glitnir
  • Nov. 6: Kaupthing

Targets Agreed with the New York Fed for End-2008

  • Creation of a central clearing house, which will start by clearing U.S. indexes and extend to other CDS contracts in 2009. The Clearing Corporation, owned by a group of major dealers, is vying with The Chicago Mercantile Exchange, NYSE Euronext's Liffe unit, the IntercontinentalExchange and others that plan to offer this service.#
  • All novations processed electronically on the same day.
  • Trades unconfirmed over 30 days not to exceed one business day of trading volume.
  • A plan that sets timeframes for achieving confirmation of electronically eligible trades on the trade date.

Backlogs

Business days worth of oustanding confirmations aged over 30 days -- a measure of efficiency of trade processing

  • June 2008: less than 1
  • March 2008: 1.3
  • December 2007: 2.5
  • September 2007: 3.5
  • June 2007: 2
  • December 2006: 3.5
  • February 2006: 7.5

Rough estimates based on line graph published by Markit.

Benchmarks

The most liquid instruments in the market are CDS on benchmark indexes that reference the five-year debt of portfolios of companies.

Markit iTraxx Europe -- based on 125 European investment-grade companies

Markit iTraxx Crossover -- based on 50 European companies mostly junk-rated with stable outlook

Markit CDX IG -- based on 125 investment-grade North

American companies

Markit CDX HY -- based on 100 North American companies that do not rank as investment grade

Underlying Companies

About 3,400 corporate names, although that includes some duplication of senior and subordinated debt of the same companies, according to Markit.

Netting

Average number of pre-netted and post-netted settlements per dealer per month

  • June 2008: pre 300,000, post 25,000
  • December 2007: pre 240,000, post 25,000
  • June 2007: pre 175,000, post 30,000
  • December 2006: pre 140,000, post 15,000
  • December 2005: pre 80,000, post 35,000
  • Rough estimates based on line graph published by Markit.

Dealers Include

Bank of America , Barclays Capital, BNP Paribas, Citigroup , Credit Suisse, Deutsche Bank, Dresdner Kleinwort, Goldman Sachs , HSBC Group, JP Morgan , Morgan Stanley , Royal Bank of Scotland, Societe Generale, UBS. (Signatories of July letter to New York Fed.)

Banks