The cash settlement deadline for Lehman is today, October 21. Based on industry estimates, a total of $6bn to $8bn is expected to have changed hands by close of business. This is approximately 1% to 2% of the $400 billion in CDS trades referencing Lehman and does not account for the effects of collateral, which will further reduce the payment amounts.
“Today’s settlement demonstrates that the industry infrastructure for CDS clearly works,” said Mr. Pickel. "ISDA and its members have developed a robust legal and operational framework that governs and guides industry participants through defaults and credit events, and that includes well-established procedures for evaluating, netting and settling outstanding trades. Recent developments in the financial markets underscore the value of the industry’s collective efforts."
"This is not to say that market dislocation is not having an effect on the derivatives industry more generally,” Mr. Pickel said. “Clearly it is: many market participants have faced major losses that have their genesis in the subprime mortgage business. This is a concern to all of us. The events of this year must be examined thoroughly for a better understanding of how they can be avoided in the future."
Mr. Pickel emphasized that the Lehman default and settlement have not created the financial disruption that critics of the CDS business have claimed. First, because the number of CDS trades outstanding on Lehman includes a significant number of transactions that offset each other, settlement payments are only a fraction – about 1% to 2% – of the approximately $400bn notional of CDS trades referencing Lehman.
Second, because firms are required to mark their positions to market and to post collateral, any additional exposure arising from the cash settlement is incrementally minimal.
And third, despite the failure of this major dealer institution – as well as several other large counterparties – the CDS business continues to function effectively. CDS contracts have been consistently more liquid than their cash market equivalents.
In addition, Mr. Pickel points out some fundamental misperceptions about the nature of CDS. The biggest misperception facing the CDS business in general is its role in today’s financial crisis. The root cause of problems of the financial sector is too many bad mortgage loans. While many of the loans were structured into mortgage backed securities (MBS) or were repackaged as collateralized debt obligations (CDOs) and sold to investors around the globe, no individual product or instrument was at fault; the economic fundamentals of those underlying exposures were simply not sustainable.
Mr. Pickel emphasized that CDS, like other privately negotiated derivatives, are bilateral, privately negotiated contracts between counterparties. The business is conducted within a sound policy framework established by policymakers, supervisors, and legislators that retains a great degree of market discipline to guide the conduct of swaps participants. Within that framework, CDS trading is subject to extensive regulatory oversight, risk management controls, corporate governance and financial reporting requirements.
“As we move forward, global public policymakers have signaled their intent to review and restructure the global regulatory framework for financial institutions and financial instruments,” said Mr. Pickel. “The industry welcomes this discussion, and we believe it will provide a forum for explaining and understanding the important benefits that privately negotiated derivatives offer to industry participants around the world. The CDS market continues to operate efficiently and the ISDA framework on which the CDS market arranges settlement of trades is providing legal and operational certainty for the industry in a time of economic uncertainty.”