Tuesday's CDS Data Generates More Questions Than Answers

It is not clear what clarity financial analysts and retail investors were expecting from the report on credit default swaps posted late Tuesday by the Depository Trust and Clearing Corporation on its website. Because beyond providing a degree of precision on the total value of outstanding CDS contracts, the report threatens to open up new debates on subjects critical to the future of Wall Street's elite institutions.

In June, the International Swap and Derivatives Association estimated that open CDS positions slightly exceed $47 trillion. On the other hand, DTCC cleared $33.6 trillion worth of bond default coverage. The gap can best be explained by the fact that counterparties to a notional value of at least $10 trillion dollars of credit default swaps have not used the DTCC mechanism.

Going beyond the debate on the size of the CDS universe, the DTCC data provides more than a few surprises, at least to observers not directly involved in the CDS market. Primarily, the quantum of insurance written on sovereign bonds (e.g. Turkey, Italy, Brazil, Russia, Argentina and Thailand) may be of immediate concern to regulators trying to ensure that there are no more hidden traps in the balance sheets of major CDS players: American International Group (AIG), Bank of America (BAC), Citigroup (C), Morgan Stanley (MS), Goldman Sachs (GS), Union Bank of Switzerland (UBS), Credit Suisse (CS) and Deutsche Bank (DB).

Evidently, Wall Street has a more-than-disclosed stake in the shape of the emerging markets through the course of this recession; apart from CDS trades based on sovereign debt, there are trillions of dollars of open currency swaps and structured projects grounded in the growth economies. DTCC did not disclose the names of the entities which sold and bought bond default risk; nor did Tuesday's report provide any insight into the ability of CDS counterparties to meet their obligations.

So it is impossible to identify which banks, hedge funds, securities firms and insurance companies are most exposed to qualitative downgrades in reference instruments. For the record, besides sovereign debt paper, corporate bonds issued by GMAC, General Electric (GE) and Merrill Lynch (MER) figured prominently in the DTCC report. (A full list of reference entities is available on the DTCC website.)

At this juncture, if only to counter the widespread attacks on the conceptual foundations of credit default swaps, the only information of real value is that which allows a cogent analysis of the risk inherent in the currently outstanding CDS positions. It is simply not enough for some to propagate the rather vague notion that a "netting" process has been and is in place, in the sheer hope that CDS counterparties have adhered to efficient risk-offset management principles. DTCC did not reveal the extent of short positions, i.e. instances where default protections buyers do not hold the referenced instruments.

It is no surprise that the people most surprised today are central bankers and government officials in Moscow, Istanbul, Brasilia, Buenos Aires, Bangkok, Beijing and a host of other capitals. A senior official of Russia's finance ministry claimed that she was totally unaware that bond underwriters were also trading Russia risk, besides performing their designated task of placing sovereign debt issues. Argentina, hit by the sharp rise in yields on its bonds recently, is already blaming CDS market-makers for a good part of the panic. Indian authorities, perturbed by reports that India's sovereign risk perceptions are being compromised by the fiscal turmoil in Pakistan, are now attempting to ascertain the extent to which the country's banks and corporations have engaged with the default risk insurance market via credit default swaps, structured projects or collateralized debt obligations (CDOs).

Without doubt, the DTCC tables prove the sheer reach of the credit default swap as a compelling product, a reach which can only expand as further bad news on the global economy creates fresh demand to purchase risk protection.

Stock position: None.