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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 2011, reporting dealers (those whose head offices are located in the G10 countries and which participate in the BIS’ semiannual derivatives market statistics) accounted for 54 percent of CDS notional outstanding. CDS contracts with central counterparties were 17 percent of notional outstanding, other banks and securities firms were 19 percent of notional outstanding, non-financial customers were 1 percent and hedge funds were about 3 percent.

How is the CDS market broken down by product type?

CDS can be written on single-name reference entities, indices and tranches. According to the Depository Trust & Clearing Corporation, single-name reference entities account for 57 percent, indices account for 35 percent and tranches account for 8 percent of notional amount outstanding as of year-end 2011.

Are CDS the cause of the financial crisis?

It's clear that CDS did not cause the financial crisis. In fact, CDS 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. CDS provide important information about credit conditions, helping bankers and policymakers to supervise traditional banking activities. And they serve a valuable signaling function—CDS prices produce better and more timely information.

Many point to the AIG situation as an example of some of the issues related to derivatives. AIG's Financial Products unit was clearly an outlier in many of its business practices and policies, and its situation reflects failure on many levels. This includes how AIG managed its mortgage risks and exposure, as well as how it managed its collateral and liquidity. It also includes the failure of the rating agencies to properly rate mortgage risks and capital adequacy, and the failure of AIG Financial Products’ regulator, the Office of Thrift Supervision, to appropriately monitor the company’s exposure (as noted in this testimony to Congress).

What about AIG, Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac?

It’s clear that all of these financial institutions took the risk of too many mortgage loans to borrowers who could not repay. Whether they took on the risk by making loans, buying mortgage backed securities, or guaranteeing loans held by others, the risks—and the results—were the same.

Regarding 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 liquidity squeeze when its lenders decided not to roll over their financing. CDS 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 CDS transactions with other firms. However, this view was belied by the fact that Lehman Brothers, which had a much larger CDS trading book, was in fact allowed to fail – and that failure did not provoke systemic risk issues.

In fact, from March (the height of the Bear situation) to September (when Lehman filed for bankruptcy), concerns had

shifted from counterparty exposure to reference entity exposure. That is to say, there were concerns about the level of CDS protection that had been written on Lehman Brothers by other firms. As events proved out though, thegross notional

exposure on Lehman was $72 billion but the net notional exposure was $5 billion. The market easily absorbed this level of payout.

As for AIG, its Financial Products 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 AIG managed its mortgage risks and exposure, as well as how it managed its collateral and liquidity. It also includes the failure of the rating agencies to properly rate mortgage risks and capital adequacy, and the failure of AIG Financial Products’ regulator, the Office of Thrift Supervision, to appropriately monitor the company’s exposure (as noted in this testimony to Congress).

Are mortgage derivatives or CDOs the same as CDS?

No. CDS, like all privately negotiated derivatives, differ in important ways from other financial products. Some collateralized debt obligations (CDOs) are sometimes called 'mortgage derivatives,' but they are very different from CDS.

CDO are securities issued to raise cash and are subject 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 MBS or ABS. In addition, CDOs are a type of debt security and represent a legal claim on assets which underlie the credit instrument.

A CDS is a bilateral contract whose key terms are negotiated between two counterparties. A CDS does not convey

ownership of underlying assets, and is not a security. A CDS 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 CDS 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 Depository Trust and Clearing Corporation’s Trade Information Warehouse, the gross notional amount of all CDS contracts outstanding was $25.9 trillion at year-end 2011 and the net notional amount as of that date was $2.7 trillion. It’s important to keep in mind that for the net notional amount to be paid out (1) every reference entity on which a CDS contract is based would have to experience a credit event and (2) the recovery rate for all of these credit events would be zero.

Counterparty credit risk is a major component of all privately negotiated derivatives activity, including CDS. Counterparty 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.

Firms hold capital against counterparty credit exposures as a matter of prudent risk management and regulatory capital requirements. That capital is typically determined on a net basis across a firm's entire derivatives exposure to a counterparty pursuant to the ISDA Master Agreement.

It is also common for counterparties to a CDS contract to post collateral. The level of collateral is typically a function of the market value of the CDS contract and the creditworthiness of the counterparties. Changes in either can result in changes to the level of collateral posted, resulting in the need to manage liquidity risk.

Another risk faced by CDS 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 exchange?

CDS 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. Exchanges generally trade standardized contracts. Requiring CDS 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. Ensuring that more ways to manage risk are available achieves a desirable phenomenon that economists call “market completion.”

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 customized risk management solutions were available.

Does anyone know who holds the risks of CDS?

ISDA helped significantly enhance transparency of the OTC derivatives industry by coordinating the establishment of trade repositories for credit, interest rates and equity products. Other 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?

Greater liquidity 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 major 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. Futures markets operate on a similar principle; 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?

ISDA and the privately negotiated derivatives business recognize 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.

One example can be seen in the use of central counterparty clearing facilities. As of January 2012, $26 trillion of credit default swaps contracts have been cleared. With the strong encouragement of the New York Fed and other global regulators, major dealers have established and publicly committed to benchmarks for clearing OTC derivatives trades. Firms are meeting or exceeding their targets. More than 90 percent of new interdealer, clearing-eligible IRS and CDS are being submitted to CCPs, and firms committed to clearing 85 percent of CDS trading and 90 percent of IRS.

The industry has also increased operational efficiency through industry-wide compression or 'tear-up' efforts, which have reduced CDS outstanding by $82 trillion. These clearing and portfolio compression efforts have helped to significantly reduce the notional amount of CDS outstanding by approximately 75 percent.

Efforts 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. More information on exposures and activity is available through DTCC’s trade information warehouse. ISDA has made available to all participants a CDS standard model that improves consistency and reduces operational differences regarding the calculation of CDS prices.