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New Rules for Credit Default Swap Trading: Can We Now Follow the Risk?

insurancenewsnet.com | July 6, 2014

By Margaret Jacobson

Credit default swaps, a useful but complex financial innovation of the 1990s, were traded over the counter before the financial crisis. Because of this infrastructure, a very opaque market emerged-and from it, the severe risk imbalances that helped fuel the crisis. Reforms are now being worked out and put in place which will move the majority of credit default swaps transactions to more transparent exchanges. Market participants will be able to see pre-trade and posttrade pricing, and regulators will have access to information that will allow them to monitor risk concentrations as they develop and take actions before they become of systemic concern.

Developed only in the 1990s, credit default swaps (CDSs) are a relatively recent financial innovation. Though they play a useful and important role in managing risk exposure, a critical weakness in their market infrastructure contributed to and amplified the financial crisis of 2008-2009. This weakness is now being addressed in some of the reforms that are in the works as a part of the Dodd-Frank Act. Successful implementation of reforms that serve to increase transparency in CDS markets is essential for avoiding future financial crises.

Before the financial crisis, CDSs were traded over the counter (OTC), where parties arranged their own individual contracts bilaterally. Unlike markets with exchanges, such as the stock market, the CDS market did not provide participants with readily available information on prices that were being paid for protection or volumes of trading activity. Furthermore, regulators were unable to follow the transfer of risk among counterparties.

The market's opacity led to extreme risk imbalances-some firms holding more risk than they were able to handle and other firms falsely confident that they were protected from risk-which were at the heart of the crisis.

Reforms, originally agreed to by the Group of Twenty (G-20) nations in August 2009 and later incorporated into the Dodd-Frank Act, aim to address the opacity of OTC markets. These reforms should help strengthen the CDS market and enable regulators to follow the risks as they are transferred from institution to institution. To assure that CDSs are transferring rather than propagating risk, regulators must be able to trace the path of risks to verify that all risks end up at institutions with sufficient capacity to absorb them.

Risk Sharing and Management

A credit default swap (CDS) is most easily understood as a form of insurance against a default on a credit, such as a bond or loan. The buyer of the protection enters into a contract with a seller-typically a financial institution that seeks a payment for taking on the risk of having to make a payment in the future. When used prudently, a CDS is an important tool that allows portfolio managers and financial institutions to share risk, and thereby manage their individual levels of risk exposure.

Figure 1 provides some illustrative examples of how CDSs have been used in risk management. The first example is that of a portfolio manager concerned about the increasing potential for a default on a $10,000 bond held in a fund. In an OTC market, the portfolio manager typically calls several broker-dealers for a quote for protection on the principal value and unpaid coupons of the bond in the event of a default.

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