Misconceptions on the Credit Default Swap Market

DTCC Addresses Misconceptions About the Credit Default Swap Market:

The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine.

The facts are these:

Central Trade Registry

In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse. In addition, all of the major global credit default swap dealers have registered in the Warehouse the vast majority all contracts executed among each other before that date.

Size of the Market

Reported estimates of the size of the credit default swap market have so far been based on surveys. These surveys tend to overstate the size of the market due to each party to a trade separately reporting its own side. Thus, when two parties to a single $10 million dollar trade each report their “side” of the trade, the amount reported is $20 million, which overstates the actual size by a factor of two since both reports relate to a single $10 million contract. When examining the outstanding amount of actual contracts registered in the Warehouse (not separately reported “sides”) as of October 9, 2008, credit default swap contracts registered in the Warehouse totaled approximately $34.8 trillion (in US Dollar equivalents). This is down significantly from the approximately $44 trillion that were registered in the Warehouse at the end of April this year.

Percentage of the Market Related to Mortgages

Less than 1% of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities. Mortgage-related index products also have some components relating to residential mortgages and, as a whole, also constitute a relatively small fraction of total credit default swaps registered in the Warehouse.

Payment Obligations Related to the Lehman Bankruptcy

One of the many central servicing functions of the Trade Information Warehouse is to calculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009.
The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).

Comments

[Freedoms Truth:]

"The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range"

$6 billion? That's all? A global market meltdown and it was only $6 billion in actual transferred losses/gains from the BK that lit the match on this meltdown? Will they offer us a refund on our investment lossses now that Armageddon is cancelled?

Paulson's decision not to save Lehman was perhaps the most expensive mistake a treasury secty ever made.

2008 Oct 12 06:11 PM

[Tom Armistead:]

Does DTCC have figures as to how much of the CDS market is devoted to genuine insurance transactions supported by an insurable interest as agianst purely speculative gambling transactions?

The NYSID now says 80 to 90% ot these contract do not involve insurable interest: that is, they are strictly speculation.

To say that few of the CDS contracts are on individual mortgage based securities my be true: however, the amount of "protection" bought on target companies in the current wave of bear raids often has no relation to the actual amount of bonds outstanding.

The 55 or 62 trillion figures that are usually given for the size of the CDS market come from ISDA. What is abundantly clear from the size fo the market is that it is grossly in excess of what would be needed to fulfill its legitimate function as insurance. The rest is gambling, speculation and manipulation.

To say the its a zero sum game is inaccurate - money from legitimate investors is sucked into this casino operation as the credit market is manipulated to a standstill based on excessvie spreads created by buying more CDS protection than there is bonds outstanding. The money lost by legitimate investors in target companies winds up as profits to those who manipulate the market using CDS.

CDS supported by an insurable interest should be regulated as insurance: all other CDS should be outlawed as contrary to public policy.

2008 Oct 12 06:39 PM

[AnonymousAlso:]

Define insurable interest. Against a bond? Against a stock? Against a line of credit? Seems like a lot of wiggle room.

2008 Oct 13 12:30 AM