Tuesday, August 12, 2008

Who's on the Other Side of That Trade, Anyway?

(WSJ MarketBeat) A growing proportion of U.S. firms are seeing credit-default-swap counterparty risk as a serious threat to global markets, and think another major financial company will go under due amid the global-markets crisis, according to a study by research firm Greenwich Associates (see below).

The study’s results, which say the proportion seeing CDS counterparty risk as a serious threat is approaching 85%, highlight the perceived concern of another financial firm going down. Only 27% of the institutions surveyed think there won’t be another casualty along the lines of Bear Stearns, Greenwich consultant Frank Feenstra said in a statement.

The research firm said of the 146 U.S. and European banks, hedge funds and investors it surveyed, most “believe another major financial-services firm will fail as a result of the ongoing crisis in global markets and they expect it to happen sooner rather than later.”

Almost 60% of the respondents expect another big financial firm will collapse within the next six months, while another 15% see it happening in six to 12 months.

“If you are looking for a silver lining in these findings, it seems that most institutions think we are currently in the most dangerous period for global financial-services firms,” Feenstra said. “Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside.”

Greenwich said nearly 80% of the firms in the study say their banks have tightened margin or collateral requirements since the outbreak of the global credit crunch. More than a quarter of those companies said the new requirements have caused them to reduce their trading activity.

Concerns about counterparty risk have caused institutions to cut back on their CDS use. Among fixed-income survey participants that employ such swaps, 62% said higher counterparty risk has caused them to limit their use.

Meanwhile, nearly two-thirds of the firms in the survey said they try to limit their concentration of exposure to a single counterparty, while three-quarters said the establishment of a centralized clearing entity would be effective in mitigating credit-default swap counterparty risk.

In Europe, institutions are “at least slightly more sanguine,” Greenwich said compared with U.S. firms surveyed. It said just more than 55% of the European companies surveyed see CDS counterparty risk as a significant danger.

Institutional Investors See Counterparty Risk As Growing Threat To Global Markets (For Immediate Release - August 12, 2008)

Amid Pullback in CDS Use, Institutions Voice Strong Support for a Centralized Clearing Entity
Tuesday, Aug. 12, 2008 Stamford, CT USA More than three quarters of the institutions participating in a new study by Greenwich Associates say counterparty risk in credit default swaps represents a serious threat to global financial markets.

After the collapse of Bear Stearns and amid widespread speculation about the financial health of other global banks, Greenwich Associates conducted a study of 146 institutions in North America and Europe to investigate how fears of counterparty risk were affecting institutional investment and trading strategies.

Thirty-seven percent of the institutions participating in the study have more than $50 billion in assets under management, and 18% more than $100 billion. Survey respondents were divided between 32 hedge funds and 114 banks and traditional long-only investors, with the majority domiciled in the United States (70%) and the remainder in Canada and Europe.

Among the U.S. institutions, the proportion that sees credit default swap (CDS) counterparty risk as a serious threat to global markets approaches 85%. Institutions in Europe are at least slightly more sanguine; with just more than 55% describing CDS counterparty risk as a significant danger. "At the other extreme are hedge funds, more than 90% of which said they see counterparty risk relative to credit default swaps as posing a significant threat to global markets," says Greenwich Associates consultant Jay Bennett.

Why are These Institutions so Concerned About Counterparty Risk?
Most of the institutions surveyed believe another major financial services firm will fail as a result of the ongoing crisis in global markets and they expect it to happen sooner rather than later. Nearly 60% of survey respondents say they expect to see another major financial services firm collapse within the next six months, and another 15% think it will happen in six to 12 months. The world's largest and most sophisticated investors are the most optimistic or at least less pessimistic than other investors.

"Only 27% of the institutions think there will not be another casualty along the lines of Bear Stearns," says Greenwich Associates consultant Frank Feenstra. "If you are looking for a silver lining in these findings, it seems that most institutions think we are currently in the most dangerous period for global financial services firms. Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside."

Tighter Margin and Collateral Requirements
Nearly 80% of the institutions participating in the Greenwich Associates survey say their banks have tightened margin or collateral requirements since the outbreak of the global credit crunch. "The survey results indicate many of the banks widely viewed as being hit hardest by the credit crisis have been the most aggressive when it comes to tightening the margin and collateral requirements imposed on their trading clients, but even banks that have emerged relatively unscathed have tightened terms," says Greenwich Associates consultant Peter D'Amario.

Of the institutions reporting that their banks have imposed stricter requirements, the majority nearly 65% say the change has not had a significant impact on their trading activities. However, more than a quarter of these institutions say the new requirements have caused them to reduce their trading activity.

Monitoring and Managing Counterparty Risk
Concerns about counterparty risk have caused institutions to cut back on their use of CDS. Among fixed-income survey participants that employ CDS, 62% say increased counterparty risk has caused them to limit their use.

Among all institutions participating, the most common method of managing counterparty risk (used by more than 70%) is to trade only with the most financially sound banks and broker dealers. Almost 65% of participants also say they try to limit the concentration of exposure with a single counterparty. About one-third of participants say they make use of cross-collateral arrangements and 5% say they use exchange products for hedging.

Strong Support for Centralized CDS Clearing system
Institutions in general support efforts to reduce counterparty risk in the credit default swap market through the establishment of a centralized clearing entity. Three quarters of the institutions say they believe the establishment of such an entity would be effective in mitigating CDS counterparty risk. Hedge funds around the world and institutions of all types in Continental Europe are among the strongest proponents of this plan, with almost 85% of each saying it would help reduce counterparty risk. Almost 60% of these institutions say they would prefer a centralized clearing platform operated by an exchange over one sponsored by banks. "Seven out of 10 hedge funds say they would rather use a clearing entity operated by an exchange than one operated by the banks," says Greenwich Associates consultant Tim Sangston.

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