What risks do the parties to a credit default swap give up and what risks do they take on?

In contrast to interest rate swaps but similar to options, the risks assumed in a credit default swap by the protection buyer and protection seller are not symmetrical. The protection buyer gives up the risk of default by the reference entity, and takes on the risk of simultaneous default by both the protection seller and the reference credit. By giving up reference entity credit risk, the buyer effectively gives up the opportunity to profit from exposure to the reference entity. The protection seller takes on the default risk of the reference entity, similar to the risk of a direct loan to the reference entity. Who are the major market participants in the CDS business? According to the Bank for International Settlements BIS!, at mid"year #$%%, reporting dealers those whose head offices are located in the &%$ countries and which participate in the BIS' semiannual derivatives market statistics! accounted for () percent of *+S notional outstanding. *+S contracts with central counterparties were %, percent of notional outstanding, other banks and securities firms were %- percent of notional outstanding, non"financial customers were % percent and hedge funds were about . percent. How is the CDS market broken down by product type? *+S can be written on single"name reference entities, indices and tranches. According to the +epository Trust / *learing *orporation, single"name reference entities account for (, percent, indices account for .( percent and tranches account for 0 percent of notional amount outstanding as of year"end #$%%. Are CDS the cause of the financial crisis? It1s clear that *+S did not cause the financial crisis. In fact, *+S generally enhance the ability of firms to manage their risks. They also help distribute risk widely throughout the system and thus prevent large concentrations of risk that otherwise would occur. *+S provide important information about credit conditions, helping bankers and policymakers to supervise traditional banking activities. And they serve a valuable signaling function2*+S prices produce better and more timely information. 3any point to the AI& situation as an example of some of the issues related to derivatives. AI&1s 4inancial 5roducts unit was clearly an outlier in many of its business practices and policies, and its situation reflects failure on many levels. This includes how AI& managed its mortgage risks and exposure, as well as how it managed its collateral and li6uidity. It also includes the failure of the rating agencies to properly rate mortgage risks and capital ade6uacy, and the failure of AI& 4inancial 5roducts' regulator, the 7ffice of Thrift Supervision, to appropriately monitor the company's exposure as noted in this testimony to *ongress!. What about A !" #ear Stearns" $ehman #rothers" %annie &ae and %reddie &ac? It's clear that all of these financial institutions took the risk of too many mortgage loans to borrowers who could not repay. 8hether they took on the risk by making loans, buying mortgage backed securities, or guaranteeing loans held by others, the risks2and the results2were the same. 9egarding Bear Stearns specifically, its mortgage exposure problems resulted in a lack of confidence from lenders. The firm relied too much on short"term funding and faced a classic li6uidity s6uee:e when its lenders decided not to roll over their financing. *+S did not in any way cause the failure of the firm. Some observers believed that a potential failure by Bear Stearns posed systemic risks due to its status as a counterparty in *+S transactions with other firms. ;owever, this view was belied by the fact that <ehman Brothers, which had a much larger *+S trading book, was in fact allowed to fail = and that failure did not provoke systemic risk issues.

In fact, from 3arch the height of the Bear situation! to September when <ehman filed for bankruptcy!, concerns had shifted from counterparty exposure to reference entity exposure. That is to say, there were concerns about the level of *+S protection that had been written on <ehman Brothers by other firms. As events proved out though, thegross notional exposure on <ehman was >,# billion but the net notional exposure was >( billion. The market easily absorbed this level of payout. As for AI&, its 4inancial 5roducts unit was clearly an outlier in many of its business practices and policies, and its situation clearly reflects failure on many levels. This includes how AI& managed its mortgage risks and exposure, as well as how it managed its collateral and li6uidity. It also includes the failure of the rating agencies to properly rate mortgage risks and capital ade6uacy, and the failure of AI& 4inancial 5roducts' regulator, the 7ffice of Thrift Supervision, to appropriately monitor the company's exposure as noted in this testimony to *ongress!. Are mortgage derivatives or CD's the same as CDS? ?o. *+S, like all privately negotiated derivatives, differ in important ways from other financial products. Some collaterali:ed debt obligations *+7s! are sometimes called 1mortgage derivatives,1 but they are very different from *+S. *+7 are securities issued to raise cash and are sub@ect to relevant securities laws. They are created by combining mortgage backed, or other asset"backed, securities into pools, then issuing new securities which are backed by those pools of 3BS or ABS. In addition, *+7s are a type of debt security and represent a legal claim on assets which underlie the credit instrument. A *+S is a bilateral contract whose key terms are negotiated between two counterparties. A *+S does not convey ownership of underlying assets, and is not a security. A *+S is created to shift risk, not raise cash. The two parties to each deal can custom"tailor the contract in a private negotiation, with more flexibility than trading on the securities or futures markets. What are the real risks of CDS? The basic risk in a *+S contract is the credit risk of the reference entity on which the contract is based. If the reference entity experiences a credit event, then the protection seller pays the protection buyer. According to the +epository Trust and *learing *orporation's Trade Information 8arehouse, the gross notional amount of all *+S contracts outstanding was >#(.- trillion at year"end #$%% and the net notional amount as of that date was >#., trillion. It's important to keep in mind that for the net notional amount to be paid out %! every reference entity on which a *+S contract is based would have to experience a credit event and #! the recovery rate for all of these credit events would be :ero. *ounterparty credit risk is a ma@or component of all privately negotiated derivatives activity, including *+S. *ounterparty credit risk is the risk that the other party to a bilateral contract will default before meeting all of its obligations. If a counterparty defaults, the other swaps participant could lose the value of the defaulted contract. 4irms hold capital against counterparty credit exposures as a matter of prudent risk management and regulatory capital re6uirements. That capital is typically determined on a net basis across a firm1s entire derivatives exposure to a counterparty pursuant to the IS+A 3aster Agreement. It is also common for counterparties to a *+S contract to post collateral. The level of collateral is typically a function of the market value of the *+S contract and the creditworthiness of the counterparties. *hanges in either can result in changes to the level of collateral posted, resulting in the need to manage li6uidity risk.

Another risk faced by *+S counterparties is operational risk, which is the potential for losses that could occur from human errors or failures of systems or controls. Why aren(t CDS traded on an e)change? *+S and other swap contracts are negotiated between two counterparties who are able to custom tailor the terms of the bilateral contracts in ways that suit them. Axchanges generally trade standardi:ed contracts. 9e6uiring *+S to trade on exchanges would force swap participants to give up the benefit of the custom tailoring that allows more precise risk management by companies, financial institutions, and governments. All of those entities are free to choose to manage their risks using exchange traded contracts, and sometimes do. Ansuring that more ways to manage risk are available achieves a desirable phenomenon that economists call Bmarket completion.C By definition, a swap must be bilaterally negotiated, which is to say, not traded on an exchange. Bilaterally negotiated derivatives exist because no exchange"traded contract can replace a custom tailored, privately negotiated agreement like a credit default swap. Trying to force bilateral participants to trade on an exchange would be a step backwards to a time before customi:ed risk management solutions were available. Does anyone know who holds the risks of CDS? IS+A helped significantly enhance transparency of the 7T* derivatives industry by coordinating the establishment of trade repositories for credit, interest rates and e6uity products. 7ther trade repositories for other derivatives products will be established in the future. Through these trade repositories, global regulators now have access to a tremendous amount of information about the marketplace and have the ability to assess risk exposure by counterparty or reference entity on an efficient, timely basis. Should firms that don(t own bonds or loans be allowed to use CDS? &reater li6uidity and better risk management result when more participants are able to shed the risks they don't want, and accept risks that they prefer. If an automobile parts company is concerned about the risk that a ma@or client will disappear, having the ability to manage part of that risk will benefit that company, its stockholders, and its employees, even if it owns no bonds or loans. 4utures markets operate on a similar principleD you don't have to own a wheat farm or a grain elevator to be able to sell wheat futures on a futures exchange. How is the industry responding to the financial crisis?
IS+A and the privately negotiated derivatives business recogni:e their responsibility to strengthen and improve the industry. The industry is being extremely proactive on a number of fronts, working cooperatively with regulators and policy makers globally. 7ne example can be seen in the use of central counterparty clearing facilities. As of Eanuary #$%#, >#F trillion of credit default swaps contracts have been cleared. 8ith the strong encouragement of the ?ew Gork 4ed and other global regulators, ma@or dealers have established and publicly committed to benchmarks for clearing 7T* derivatives trades. 4irms are meeting or exceeding their targets. 3ore than -$ percent of new interdealer, clearing"eligible I9S and *+S are being submitted to **5s, and firms committed to clearing 0( percent of *+S trading and -$ percent of I9S. The industry has also increased operational efficiency through industry"wide compression or 1tear"up1 efforts, which have reduced *+S outstanding by >0# trillion. These clearing and portfolio compression efforts have helped to significantly reduce the notional amount of *+S outstanding by approximately ,( percent. Afforts are underway to enhance market transparency in several important ways. This includes increasing the flow of information on the derivatives business to the regulatory community as well as to the general public. 3ore information on exposures and activity is available through +T**'s trade information warehouse. IS+A has made available to all participants a *+S standard model that improves consistency and reduces operational differences regarding the calculation of *+S prices.