It’s Time to Stop the Nonsense

It’s hard to overstate the amount of nonsensical chatter on credit default swaps (CDS) in the past few days.  At the top of our list is a column by physicist Mark Buchanan in Bloomberg BusinessWeek.  It says that CDS make today’s sovereign debt crisis “different – and possibly more dangerous” because they create a “largely invisible network of ties among institutions around the world, which could ultimately cause global financial chaos.”   That’s because CDS are “mostly arranged ‘over-the-counter,’ not traded on any exchange or recorded by any central information repository.”


Does the author not know about DTCC’s CDS Trade Information Warehouse?  (For that matter, doesn’t anyone at Bloomberg BusinessWeek know about it either?)  It’s only been up and running since 2008, capturing more than 98% of all CDS transactions.  Its launch may not have rivaled the neutrino time trials recently carried out by CERN in Europe.  But surely its existence should be known to someone purporting to be an expert on the CDS market.

The CDS warehouse offers a significant level of regulatory transparency and helps to ensure that AIG can’t happen again.  Some of the information it captures is public and is available here.

Note in Table 6 of the DTCC data that the net notional on Greek debt currently measures US$3.7 billion.  This figure is calculated by summing the net exposures of the protection sellers, so it is impossible for any one firm selling protection to have more than $3.7bn in exposure.  Of course, given that there are many net sellers, any one seller’s exposure is likely to be far less.

Also, firms’ net exposures are partially offset by the recovery value of the underlying obligations. For example, if the post-default recovery value of Greek debt was (hypothetically) 50%, the maximum aggregate amount payable would be 50% of $3.7 billion, or $1.85 billion. Furthermore, statistics indicate that, on average, 70 per cent of derivatives exposure is collateralised and the level of CDS collateralization is likely to be even higher as over 90% of CDS transactions (by numbers of trades) are collateralised. Thus, in this example, of the $1.85bn that would be payable, about $1.5bn is secured.

So please, let’s stop the nonsense. There are serious issues to be discussed regarding global regulatory reform and the financial markets.  Greater transparency and the threat of CDS contagion in the event of a Greek default aren’t among them.

4 thoughts on “It’s Time to Stop the Nonsense

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  2. Thanks for the update. I was aware of the DTCC clearing site and had seen the $3.7B net number previously. Further, your calculus is helpful and appreciated.

    Having said that, your assertion that “it is impossible for any one firm selling protection to have more than $3.7bn in exposure” is interesting. While I would agree that aggregate netting of the notional amount down to $3.7B is encouraging, it doesn’t mean that the exposure of individual institutions could not vary from, and perhaps significantly exceed, the industry-wide net number.

    And that brings us to the challenge with the DTCC data. Rightfully, to protect proprietary interests, it doesn’t show firm-level commitments. The concern lay people have is that, as we’ve seen with MF Global, counter parties will fail due to sovereign or other exposure. Further, that the failure of one significant counter-party could endanger others.

    So, it might be helpful if in the next post, you devote some time to allaying this fear. Topics might include:
    1. The minimum tangible capital requirements for firms underwriting these insurance-like products.

    2. The ongoing margin requirements used to insure CDS positions.

    3. The level of insurance provided to counter-parties by the exchange.

    4. The level of insurance reserves held by the exchange relative to the notional amount outstanding.

    Armed with answers to these questions, I’m sure you’d see the level of concern change.

    • speaking as a lay person I am very interested to know the details of how the CDS warehouse, though it does provide a welcome element of transparency and some tangible figures, ‘ensures AIG won’t happen again.’

      The fact that the information is available to regulators does not commit them to addressing the issues and I would be interested in seeing further details along the lines mentioned by the previous poster. My understanding was that AIG’s impending collapse was due to ever increasing collateral requirements demanded by its clients which eroded its substantial capital base and therefore potentially rendered it unable to meets its obligations on the CDS it had written.

      Similarly, as much of the sovereign CDS is being provided by investment banks and institutions which in the recent crisis faced similar problems, i.e. that as the collateral demanded by providers of their short term funding increased they found their capital eroded and their assets to be increasingly illiquid in a deteriorating global credit environment; and that they appear to be hedged with protection from similarly vulnerable institutions, calling into question the validity of their ‘netting’ strategies; it is unclear to me how transparency within an information warehouse corrects this potential systemic risk.

      I appreciate that these concerns are predictably similar to those which are being expressed by others but, given the chaos which resulted in the last credit crisis and the seeming absence of tangible regulatory reform, I’m sure you can appreciate the tension amongst us lay people.

      Also, if all owners of Greek debt for example can buy protection against a default and the total losses incurred by those offering the insurance does not exceed $3.5 billion, then why are we being constantly told that we are on the verge of a crisis which requires a $1trn bailout fund?

      Apologies if the answers to these questions are glaringly obvious but if there are in fact solid checks, balances and protections in place then I think they should be made more public as I think this will alleviate the concern (and dare I say some of the resentment) which is currently being directed at the financial sector.


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