Here is a prime example of a ‘Big Bang’ protocol that appears to be working – at least, for the regulators concerned.
Bloomberg reports on Wednesday that credit-default swap dealers slashed their market by 38 per cent last year as regulators pushed them to reduce risk, according to the International Swaps and Derivatives Association:The notional value of credit-default swaps outstanding plunged to $38.6 trillion as of Dec. 31 from $54.6 trillion mid- year and $62.2 trillion at the end of 2007, the New York-based ISDA said in a survey published in Beijing today. “In the current environment, firms are intensely focused on shrinking their balance sheets and allocating capital most productively,” said ISDA Chief Executive Robert Pickel, whose group represents dealers that control trading.After CDS were blamed for causing all manner of ills from Lehman’s collapse to AIG’s near-collapse, more than 2,000 banks, hedge funds and asset managers trading CDS agreed to a ‘Big Bang Protocol’ in April. The new ‘protocol’, aimed at improving transparency and confidence in the contracts, came after regulators including the Federal Reserve Bank of New York called for an industry overhaul, the report adds.
Amazing what a bit of transparency-improvement initiative can do. After the collapse of Bear Stearns last year, 17 banks that handled about 90 per cent of trading in credit derivatives agreed to follow steps including tearing up trades that offset each other to help reduce day-to-day payments, bank staff paperwork and potential for error. The tear-ups don’t reduce the actual amount of default and market risk outstanding, but “may reduce the amount of capital commercial banks are required to hold against the trades on their books”, explains Bloomberg.
This follows the US banking industry’s first loss in derivatives trading last year, when commercial banks lost $836m trading OTC cash and derivatives contracts, including $9.2bn in the fourth quarter, compared with a $5.5bn gain in 2007, according to the Office of the Comptroller of the Currency.
The only downside of the new push to reduce risk and increase transparency, if followed to the letter, is that it will become harder to blame corporate and financial distress on the CDS market.
In an ongoing discussion about the impact of the CDS market – or more specifically, the appeal of buying credit protection – on corporate bankruptcies, Felix Salmon in a recent post on Reuters makes another point about the pitfalls of the market:
I fear that the growth of the CDS market has made it altogether too easy for bond investors to simply rid themselves of troublesome considerations pertaining to companies in distress. Selling distressed bonds outright is extremely unpleasant; buying enough protection to limit your downside, by contrast, is simply prudent. Once you’ve done that, who can blame you for not getting bogged down in negotiations?
At the margin, he notes, “anything which makes it easier to ignore bond-restructuring negotiations is going to be jumped at by the creditors of any company. Given the choice between buying credit protection and entering into negotiations, most bondholders will happily buy the protection, even if it costs them a little bit more money”.
It’s far too early to say whether we’re going to see more bankruptcies as a result of this phenomenon, or even whether that’s necessarily a bad thing. But I do think it’s a legitimate concern.
Related links:
Credit swap dealers shrink market by 38%, ISDA says – Bloomberg
Do CDS cause more bankruptcies? – Felix Salmon