Credt Default Swaps and Counterparty Risk

This is a summary of a recent publication by the European Central Bank on the topic of credit default swaps and counterparty risk. It is a worthwhile reading. Given that the length of the paper is somewhat extensive, I have provided a brief report of its content. The full version of the paper can be read here.

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· Credit default swaps (CDS) are bilateral contracts that work similar to insurance policies. A purchaser of a CDS agrees to pay a periodic fee (i.e. premium) and/or an upfront payment in exchange for a payment by the CDS seller in case of a credit event (e.g. bankruptcy, credit downgrade, etc.) in the underlying reference.

· In terms of notional amounts outstanding, CDS comprises about 7% ($42 trillion) of total OTC derivatives as of year-end 2008. Interest rate swaps are the lion’s share of OTC contracts.

· In terms of gross market value, which considers the cost of replacement, CDS grew from $133 billion in December 2004 to approximately $5.7 trillion in December 2008.
Several key observations:

· High concentration of CDS dealers. The top 5 firms comprised approximately 50% of the total outstanding notional amount according to DTCC data. Four are ANC firms: JP Morgan (#1), Goldman Sachs (#2), Morgan Stanley (#3), Barclays Group (#5).

· CDS market has come to demonstrate a high level of interdependence (i.e. connection), which manifests itself in various ways:
(1) Market values of financial firms tend to fluctuate together.
(2) There is an increasing correlation between counterparty and reference entities (e.g. a bank that received government assistance and at the same time sold CDS on the sovereign credit risk of the country that is domiciled—this is known also as “wrong-way risk”).
(3) It was noted that less important CDS players in fact turned out to be critical for the market, as their failure would have severely impacted the “too big to fail” firms (e.g. AIG and its counterparties).

· Circularity of risk. This term relates to when national governments provide economic support to financial institutions. This results in the latter firms being stabilized, however the national government’s additional burden increases sovereign risk; thereby increasing the risk for bank.

· A CDS has a call-type option for the defaulting counterparty. That is, the increase in the contract’s market value is a benefit for the defaulting counterparty. The party suffering the loss typically uses 3 approaches to minimize this risk:
(1) Price the CDS to consider counterparty risk. This may entail different price for each counterparty.
(2) Hedge in such a way to consider the counterparty defaulting during the life of the CDS. (3) Require collateral to cover replacement cost. · Collateral is the primary way for firms to manage this risk. In a CDS framework, CDS buyers receive collateral when spreads are widening and vice-versa when spreads are declining.

· Unlike other OTC derivatives, CDS contain both credit and counterparty risk.

· What makes CDS particularly risky vis-à-vis other derivatives is the credit risk distribution of the underlying reference entity is skewed (i.e. non-symmetric). As a result exposure levels during market turbulence for the CDS buyer from the CDS seller could increase significantly. This could cause potentially enormous payouts from the latter to the former. In such instances not only counterparty risk is an issue but also liquidity risk.

· CDS markets are used as price indicators for other markets, including loan, credit, and equity markets.

· CDS spreads tend to lead changes in bond spreads in the short run.

· In theory, CDS spreads should provide a pure measure of default risk.

· A rough approximation of CDS spreads = (PD)*(1 - recovery rate) = PD*LGD.
PD = Probability of Default
LGD = Loss Given Default

Research demonstrates that PD and LGD may be cyclically positive correlated, implying that during economic downturns recovery rates suffer disproportionally in relation to PD, which will ultimately increase CDS spreads. Systemic risk can also negatively affect spreads.

· In abnormal market conditions, there is a breakdown in the interrelationship between CDS market and the underlying cash bond market as a means of reference pricing. Cash market reflect credit risk and funding risk, whereas the CDS market focuses on credit risk and counterparty risk. This mismatch has been attributed to periods of reduced liquidity.