Sticking Issues with Credit Default Swaps

I’ve talked to three people with an inside line on negotiation with “founding members” of the Intercontinental Exchange (ICE) and the Chicago Mercantile Exchange (CME) units that want to float a proper credit default swap [CDS] market.

For now, these seem to be the sticking issues: How much capital will the members need to lock up? And margin requirements - some companies balked at a two tier margin requirement - wherein:

a. One of the parties involved in the CDS is the bond-holder. In this case, it would make sense for the bond-holder to get into a swap with a party betting on the default of the bond-holder. The initial margin requirement for the seller of the CDS the “insured” would be zero, as they are long the bonds in question. Maintenance margin requirements would kick in if the bonds are marked down to 40% of the CDS’ notional value [similar to Regulation T for stocks].

b. If the “insured” party is not long the bond, the last I heard, the “founding members” balked at a 10% initial margin requirement.  Remember that in the world of CDSs, there are no deductibles. The insurer pays for all losses - including those from “markdowns”.

In the second scenario, the margin requirements are so large - that anyone participating in a CDS would have to lock a huge amount of capital “defending” their position- which would decimate the market size from a now $55 Trillion to less than $10 Trillion [per my calculations - which are generous to ICE/CME].

For an simple explanation of how CDS’s work, please look at an older article of mine.

Comments

[Nick Gogerty:]

Just a thought experiment, but if all CDSs were put on a centralized exchange today even considering the notional amounts outstanding netted down to 10% of the $62 trillion figure that roughly $6.2 trillion, assuming an average of lets 25% of that for the average margins one still ends up with $1.6trillion in margin required that is still a lot of change to come up with.

2008 Oct 29 11:01 AM

[MCC280:]

That seems to be the point of the exchange clearing model, $1.6 trillion is huge margin to put up but it represents a responsible amount of good faith money to make these trades. I think what it will do is turn swaps into the risk management devices they were intended to be, meaning swaps trading will become less about proprietary trading and more about a means managing risk. The scale of this market is way too large as it is in my opinion, bringing transparency will provide real mark to market valuations that will in turn give people a picture of the real default probability of a company via the transparent and aggregate opinion from all market participants. Perhaps if you see the real price of default protection through a transparent market you might not feel the need to hedge with CDS's? The margin requirements are justified, as it is to write a swap you need no capital to back it and I think the margins will prevent people from taking undue risks for profit because with margins you can't take the risk without the capital to initiate the trade. The flip side to this is that it forces banks and dealers invent another derivative our source of bankruptcy "protection" on their own terms. Now I'm only a fresh-faced 23 year old, so to call my self a novice in terms of this stuff would be a very generous evaluation of my knowledge. Although it seems that the people dealing with these swaps didn't understand them either. Purely opinion and any thoughts, criticism, or more information would be appreciated.


On Oct 29 11:01 AM nickgogerty wrote:

> Just a thought experiment, but if all CDSs were put on a centralized
> exchange today even considering the notional amounts outstanding
> netted down to 10% of the $62 trillion figure that roughly $6.2 trillion,
> assuming an average of lets 25% of that for the average margins one
> still ends up with $1.6trillion in margin required that is still
> a lot of change to come up with.

2008 Oct 29 02:27 PM