(Bloomberg) -- An effort to scale down the $62 trillion credit-default swap market by eliminating duplicate trades may cut the amount of some outstanding contracts between banks by as much as 75 percent.
Tests conducted this month by broker Creditex Group Inc. and derivatives data provider Markit Group Ltd. show that a cluster of $100 million in outstanding credit-default swaps, for example, may be cut by $50 million to $75 million as the derivatives are offset with new, smaller trades.
So-called tear-ups may help tame a market that over seven years grew almost 100-fold from $632 billion, raising concern it became unwieldy and a threat to the financial system's stability. Prompted by the , credit derivatives dealers including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc. committed last month to a plan that would reduce errors and speed up trading.
``The early testing that we've done with the banks has been very smooth,'' Mazy Dar, chief strategy officer at New York-based , said in an interview.
Credit-default swaps are privately negotiated contracts between banks, hedge funds and other investors that are used to speculate on a borrower's creditworthiness or to hedge against losses. The derivatives, which aren't traded on an exchange, pay the buyer face value in exchange for the underlying securities or the cash equivalent should the company fail to adhere to its debt agreements.
The tear-ups will aid another initiative by credit-default swap dealers to start clearing their trades this year through Chicago-based Clearing Corp., which will act as a central counterparty to the banks, said Jason Quinn, head of high-grade trading at New York-based Lehman.
``It shows that we're actually being forward-thinking about moving this to a clearing type of a system,'' Quinn said. ``This effort makes it much easier for that to be seamlessly put in place.''
New York Fed President Timothy Geithner has pushed banks to improve processing of credit-default swaps since 2005, when a backlog of unsigned trades raised concern of a market collapse. After a run on Bear Stearns Cos. in March led to an emergency sale of the firm to , regulators grew concerned that the collapse of a derivatives dealer such as Bear Stearns could spark a wave of losses across the market. Geithner stepped up pressure on dealers to make changes.
The trade tear-ups and the central clearinghouse, which will be designed to absorb the failure of a market-maker, were part of a list of initiatives agreed to last month by the Fed, dealers and industry groups.
Cutting Payments, Paperwork
The testing by Creditex and Markit so far doesn't suggest that the entire market of outstanding contracts will be cut in half, and trade compression won't reduce the amount that banks, hedge funds and other investors have at risk in the market.
Rather, the initiative will eliminate contracts sitting on bank trading books that effectively duplicate others, cutting down on the day-to-day payments, paperwork and monitoring by bank staffs and reducing the potential for errors, Creditex and Markit said earlier this month in announcing the project. It also may reduce the amount of capital that commercial banks are required to hold against the trades on their books.
The effort is only targeting trades between banks, and some banks may not agree to participate in all trade tear-ups because it may cause them to breach limits on the amount of exposure they allow themselves with a single bank, Dar said.
``You can only compress trades between the dealers that are participating, he said. ``And, there are counterparty exposure limits.''
The first round of cancellations is expected to start next month, Dar said, at first focusing on contracts that are linked to companies in North America and Europe.
``People want to see it work in the U.S. and Europe, and then once they're comfortable, we'll extend it to Asia as well,'' Dar said.