Wednesday, September 24, 2008

Credit Derivatives Market Shrinks for First Time on Tear-Ups

(Bloomberg) The credit-default swap market, used to hedge against bond losses and speculate on corporate credit risk, shrank for the first time as efforts to eliminate duplicate trades cut contracts outstanding by 12 percent.

The volume of outstanding trades fell to $54.6 trillion from $62 trillion in the first half, the International Swaps and Derivatives Association said in a statement today. It was the first decline since ISDA started surveying traders in 2001.

``This decrease primarily reflects the industry's efforts to reduce risk by tearing up economically offsetting transactions and demonstrates the industry's ongoing commitment to reduce risk and enhance operational efficiency,'' ISDA Chief Executive Officer Robert Pickel said in the statement. ``We expect to see more effects of this over time.''

Outstanding contracts had grown 100-fold over the past seven years as insurance companies, hedge funds and investors used the contracts to speculate on corporate creditworthiness. Traders last year rushed to unwind trades or hedge against losses as credit markets locked up amid the worst U.S. housing slump since the Great Depression.

The market has likely shrunk even more since ISDA's poll after one of the 10 largest market-makers, Lehman Brothers Holdings Inc., filed for bankruptcy this month. ISDA's survey captured trading as of June 30.

``I would expect that if they were to re-poll next week, you would see an even smaller number from netting activities and trade cancellations surrounding the Lehman Brothers default,'' said Brian Yelvington, a strategist at CreditSights Inc. in New York.

Scaling Back

After the March collapse of securities firm Bear Stearns Cos., 17 banks that handle about 90 percent of the trading in credit derivatives agreed to a list of initiatives to curb market risks. That included tearing up trades that offset each other, which cuts down on the day-to-day payments, paperwork and monitoring by bank staffs and reduces the potential for errors. It also may reduce the amount of capital that commercial banks are required to hold against the trades on their books.

The first stage of compression, completed Aug. 27, with the participation of 14 dealers, reduced contracts submitted on North American telecommunications companies by 56 percent, Markit Group Ltd. and Creditex Group Inc., which are processing the tear-ups, said this month. The second stage, completed Sept. 4, with 15 dealers, cut contracts on European telecommunications companies by 53 percent.

Potential Regulation

The industry's initiative to scale down the market also comes as state and federal authorities look to impose regulations on the market for the first time since it was created a decade ago.

U.S. Securities and Exchange Commission Chairman Christopher Cox yesterday told the Senate Banking Committee that Congress should ``immediately'' grant authority to regulate the market amid concern that trading is fueling the financial crisis.

New York Governor David Paterson said in a statement on Sept. 22 that the state will start regulating some of the derivatives by deeming them insurance and requiring sellers to be licensed.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should the borrower fail to adhere to its debt agreements.

Other derivatives markets grew, ISDA said in the statement today. The notional amount of derivatives used to hedge against changes in interest rates increased 22 percent during the first half of 2008 to $464.7 trillion. Contracts linked to equities grew by 19 percent to $11.9 trillion.

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