Financial Regulation

Briefing Notes on Regulation : Credit Deafult Swaps

This week the credit default swaps market went through a momentous change that in time could dramatically affect that market. The International Swaps and Derivatives Association (ISDA) overhauled the $27 trillion market for credit default swamps on corporate and sovereign debt by standardizing the terms of many of these instruments and incorporating characteristics that will bring them more in line with the underlying bonds. Aptly named the Big Bang by ISDA, some 1,800 market participants including banks, hedge funds and money managers agreed to the new standards.

Standardizing swaps’ terms makes them more transparent and facilitates trading. It is a direct and effective way to address the accusations that the market is too opaque. Also standardizing the terms is a significant step toward centralized clearing and when necessary settlement of these swaps. By comparison achieving the standardization of the terms of interest rate swaps was a much longer and more difficult process. Far less than 1,800 market participants agreed to the new protocols on day one, which by comparison is a good reason for calling this the Big Bang.

As significant as these changes are not all CDS market problems are solved. Notably not all CDS are covered. Omitted are CDS based on mortgages and convoluted underlying instruments; just the type of CDS that AIG specialized in insuring. Also issues regarding concerns over counterparties to these swaps will be solved only when there is a clearinghouse involved that has sufficient financial backing to ensure participants that counterparty defaults in their obligations will be covered by the clearinghouse.

Minimal resistance from banks is surprising given that this will adversely affect their profit margins on these instruments. The history of fixed income markets demonstrates that once a sector becomes transparent the spread (between the bid and the offer) shrinks dramatically. I suppose the banks were being realistic recognizing that maintaining previous market practices would ensure a small to non-existent trading environment. If anything transparency in markets generally results in an increase in their size. As the expression goes, you can make it up in volume.

Ben Wolkowitz Headstrong April 9, 2009