(Bloomberg) -- Dealers including Lehman Brothers Holdings Inc. are considering changing credit-default swap contracts to more closely resemble cash bonds, following pressure to reduce risks in the $62 trillion market.
Lehman last week began offering clients the ability to trade some credit-default swaps with a fixed coupon, much like a corporate bond, and is advocating making it a standard across the market. Right now, the contracts trade on yield spreads that fluctuate.
``It's our opinion that standardization at this stage would promote more market participants and more liquidity,'' said Jason Quinn, head of high-grade trading at New York-based Lehman. ``It makes the market cleaner.''
Lehman, Goldman Sachs Group Inc., JPMorgan Chase & Co. and 14 other firms that handle about 90 percent of trades in have been under pressure by regulators to better manage risks in the market, which over seven years grew almost 100-fold from $632 billion. Lehman's experiment would complement industry efforts to create a central clearinghouse and to curb duplicate trades by compressing them into new, smaller ones.
Trading on a fixed coupon ``makes a lot of sense'' to improve market operations, said Jeffrey Kushner, a managing director at BlueMountain Capital Management LP, one of three asset management firms that met with the banks and regulators in June to seek ways to ease market risks.
``If you start couponing things at the same level, it makes it much easier to collapse them,'' Kushner said. ``It also makes it easier to value them.''
Lehman is only offering the fixed-coupon option so far for contracts linked to homebuilders, Quinn said. The company would consider extending the fixed-coupon option for credit-default swaps to other sectors if customers demand it, he said.
``It's definitely been discussed and is an intriguing idea,'' said Doug Warren, head of North American credit trading at Barclays Capital in New York. ``I wouldn't say that at this point there's a resounding demand that we move that way. The problem is it's clearly a big change from the way business is done today.''
The move could reduce so-called jump-to-default risk, which in some cases has curbed investors' ability to unwind trades because of the risks dealers would face by doing so.
The banks are establishing a central clearinghouse through Chicago-based Clearing Corp. that's designed to absorb the collapse of a major dealer. The dealers also are working with broker Creditex Group Inc. and data provider Markit Group Ltd. to eliminate duplicate trades. The effort may, on average, cut the amount of some contracts outstanding by at least 50 percent, said Mazy Dar, Chief Strategy Officer at New York-based .
Goldman spokesman Michael DuVally declined to comment. spokeswoman Tasha Pelio didn't return a telephone message. Deutsche Bank AG spokeswoman Renee Calabro and Morgan Stanley spokeswoman Jennifer Sala didn't respond to requests for comment.
Dealers already use fixed coupons when trading contracts on benchmark indexes such as the Markit CDX North America Investment Grade Index, which is linked to 125 companies with investment- grade ratings in the U.S. and Canada. Upfront payments also are exchanged for contracts on companies that trade near or at so- called distressed levels, typically more than 1,000 basis points.
For most contracts linked to individual companies there is no fixed coupon. Effectively, it's as if dealers each day create hundreds of ``synthetic'' bonds with different coupons, or the premiums paid to the investor taking on the risk that the company will default. The actual payments on those trades are pushed out to future dates each quarter, and no cash is exchanged upfront.
That hadn't been much of an issue until the credit crisis that began last year caused the cost to protect against a default to rise from almost record lows to record highs, said Brian Yelvington, a strategist at CreditSights Inc. in New York.
Banks and securities firms including Lehman and JPMorgan profit from credit-default swaps by selling default protection at one level and then buying it at a lower level. A bank, for example, may demand $45,000 a year to protect $10 million of Caterpillar Inc. bonds from default for five years. The bank may then buy five years of protection from another bank at $40,000 a year.
The risk of losses from such trading strategies has been amplified amid the credit crisis, Yelvington said, as the cost of protecting companies including mortgage lenders and , in some cases, jumped 20-fold.
Managing the Book
For example, an investor that had bought five years of protection on Armonk, New York-based bond insurer MBIA Inc. last year at 85 basis points, or $85,000 per $10 million in debt, would have made $1.41 million by selling the contract when the cost later jumped to 450 basis points, Glen Taksler, a credit- default swap strategist at Bank of America Corp., wrote in a note in November.
While the investor typically would get a $1.41 million payout from a bank to exit the trade, the bank would have to wait at least four years before being able to start earning a profit on income from a new trade where no cash would be exchanged upfront, according to the report. If the company defaulted the next day, the dealer, having not yet received any income from the new trade, would lose the $1.41 million he paid to the investor, something known as jump-to-default-risk.
If all credit-default swaps were traded with fixed coupons, the dealer in such a case would get an upfront payment on the second leg of the trade, reducing the risk of losses and improving liquidity, Barclays' Warren said.
``It does reduce your jump-to-default risk, and it will change the way you risk-manage your book,'' Warren said.