Based on a protocol and auction process developed by ISDA, protection sellers paid 91 cents on the dollar to protection buyers. An estimated $6bn to $8bn was paid out. Over the past 25 years, the privately negotiated derivatives industry has developed a robust framework – one that governs and guides participants through such an event, and which includes procedures and processes for valuing and unwinding trades. Recent defaults show the value of these efforts – the industry’s infrastructure clearly works.
Just as clearly, the Lehman default and settlement are not the financial catastrophe CDS critics claimed they might be. The widely cited industry estimate of $400bn in notional amount of Lehman CDS trades outstanding includes a significant number of offsetting transactions. Dealer firms generally have minimal net exposure via CDS; if they sell protection, they also generally buy protection to offset the risk. Net these positions out and net amount of risk transferred is a low single-digit percentage of the notional amount. Cash payments on Lehman were about 91 per cent of that net amount.
Two more points must be kept in mind. First, companiees are required to mark positions to market, and they have already calculated the impact of Lehman’s default on their financials. Second, companies require counterparties to post collateral to back their exposures, so most of the $6bn-$8bn paid out was already collateralised. The bottom line is that groups had little incremental exposure to the Lehman cash settlement.
It’s also worth noting that, in spite of the failure of Lehman, as well as several other large counterparties, the CDS business continues to function effectively. CDS have proven to be the main – and sometimes the only – way to shed risk or express a view on market behaviour. While cash, securities and money markets have seized up, the CDS business still operates.
Why, then, all the drama about CDS? It starts with some fundamental misperceptions. CDS, like other privately negotiated derivatives, are bilateral, privately negotiated contracts between counterparties.
The business is conducted within a sound policy framework fashioned by regulators, legislators and participants; within that framework, CDS trading is subject to extensive regulatory oversight, risk management control, corporate governance and financial reporting requirements.
Banking supervisors, and other financial regulators in each country, oversee and limit the risks taken by those they supervise, including the risks of exposure to counterparties on CDS and other credit products. The exposures of systemically important institutions to CDS are known, both by the managers of those institutions and by their regulators. Because of their ability to provide real-world solutions to real- world companies, the volume of CDS notional outstanding has increased significantly. Today, it measures about $55,000bn. This number represents the protection sold on more than 1,000 CDS “reference entities” across the world. After factoring out offsetting positions, the number is about $1,000bn, a big reduction but still a large number. Most of this amount is, as per Lehman, collateralised.
Perhaps the biggest misperception about the CDS sector is its role in today’s financial crisis. The root cause of the financial sector’s woes is too many bad mortgage loans. While some observers point to AIG’s use of CDS as contributing to its downfall, the truth is that the company, like others, took on the risk of too many defaulting mortgages and troubled loans.
Global policymakers intend to review the regulatory framework for financial institutions. The industry welcomes this discussion as it will provide a forum for explaining and the benefits privately negotiated derivatives offer. Such derivatives are a global activity – as well as an important source of innovation and growth.