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CDS Risks

The CDS market has grown exponentially to the current estimate of more than $60 trillion and has been traded and used extensively for hedging purpose by banks, insurance companies and hedge funds.

There has been a lot of discussion of the risks associated with CDS since the collapse and rescue of Bear Stearns on 17 March 2008.

Concentration Risk

The fact that CDS contracts are over-the-counter i.e. bilateral and concluded privately means that it is difficult for market regulators to monitor the market and there is a concern that such a big market should remain unsupervised. The US Office of the Comptroller of the Currency tracks transactions carried out by commercial banks but not investment banks such as Goldman Sachs.

For example, it is estimated that 60-70% of ultimate CDS protections are written by a few “monoline” bond insurers (e.g. AMBAC, MBIA) and hedge funds and that the failure of one or more could trigger a systemic failure of the market.

Investment banks like JP Morgan which acts as buyer and seller of protection and holds large position (estimated to be close to $8 trillion in the case of JP Morgan) in the CDS market. While in theory protections bought and sold are “collapsed” or cancelled out so that the net position could be much smaller, it is not difficult to imagine the failure of such a big player would result in a chaotic unwinding which destabilises the whole market.

Counterparty Risk

The protection purchased from a protection seller will be worthless if the same cannot meet its obligation. A recent report by Barclays Capital estimated that the failure of a dealer with $2 trillion could lead to losses between $36-47 billion for counterparties.

In the case of Bear Stearns for example, when CDS spread shot past 600 in March following rumours of a possible collapse, there was a real concern that it would trigger a chain of defaults by other protection sellers. Some argue that it was such a catastrophic scenario which prompted the Federal Reserve to step in and take a number of other measures to stabilise the market.

While it is true that most banks have system in place to guard against counterparty risk e.g. requiring collateral to be posted to minimize the risk, huge uncollateralized positions remain at big banks such as JP Morgan. ACA Financial Guaranty, for example, was reported to have sold $69bn protection when it only had $425 million capital. The market is also concerned about the positions held by hedge funds as the amount and ultimate holders of risk are not clear.

Documentation and Operational Risk

The situation is not helped by the delay in completing trade documentation which has been a major issue between regulators and the industry. Complex documentation issue about deliverable obligations, credit events and settlement may result in mismatch of risk as illustrated by Aon Financial Products v Soc Gen.

In the case of contracts where physical settlement applies, there is an additional risk relating to the ability of the protection buyer to source the bonds if the outstanding CDS contracts are greater than available bonds. In the credit event relating to Delphi, there was estimated to be $28bn CDS outstanding against $5.2bn available deliverable obligations. The shortfall could be greater in more actively traded names. Use of CDS protocols organised by ISDA, a process which converts physical settlement to cash settlement, has helped to alleviate the problem but the final price obtained from the auction process may be lower than the actual loss suffered by the protection buyer.



derivativeslawyer.com

Last updated April 2008

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The above notes are intended to highlight issues and provide only general outlines and not intended to be comprehensive nor legal advice. Where applicable, the same should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They shall never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof. If you have any question, please contact us.

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