Insight: The CDS sector is not the central villain

Last week saw an important milestone in the credit default swaps sector, when counterparties to CDS trades on Lehman Brothers cash-settled their transactions.

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.

Originally published at the Financial Times and reproduced here with the author’s permission.

91 Responses to "Insight: The CDS sector is not the central villain"

  1. 888   October 31, 2008 at 8:25 am

    I glad there isn’t much to be concerned with.

  2. villager   October 31, 2008 at 10:03 am

    Miss America aptly named his artice yesterday, “Trick or Treat”. In this context, Robert Pickel is not offering any “treats” for sure. Beware, Pickels’s masterpiece is full of “tricks”. Happy Halloween!

  3. Guest   October 31, 2008 at 11:31 am

    well,it’s not the bullet but the hole that does the damage. it’s not the cds but the misuse that is so destructive.?the cds makes possible the securitization of collateral which makes bank reserves irrelevantas a limit on credit which accelerates the appreciationof assets as speculators and investment bankswork the system. this results in a transfer of wealth from the collateral asset owner to the virtual or shadow financial sytem resulting in the american nightmare. never ending debt. happy halloween. trick or cds?blind man.

  4. duped again and again   October 31, 2008 at 4:20 pm

    If these CDS bets “kind of offset each other”, then why write them? Just to get fees and make the system entangled beyond repair?This explanation is one of the most phony argument that one can get from a person who is not in a position to provide an honest an independent expert opinion about the CDS and derivative problems.The reality is proving him wrong so far and very quickly even this guy will be against his own current argument.That is not to say that he will not come up with some new ones. But the system seems to be on a irreversible path to meltdown already and his arguments will soon become irrelevant.

  5. Guest   October 31, 2008 at 5:05 pm

    The author’s feet are firmly planted in the air while whistling past the graveyard. Well, BOO!!! Recent estimtes are as high as a quater quadrillion dollars in notional value as recently echoed by Muriel Siebert a few days ago on CNBC. If settlement value through these new cds exchanges is let’s say 10% doesn’t that still add up to $2.5 trillion and leave a gaping hole in hedge fund balance sheets? Certainly not chump change and enough to drive further liquid asset sales. The government takes control on a whim right? Please? Hedgies are lining up already or do I misunderstand?GLTA

  6. Guest   October 31, 2008 at 9:42 pm

    So no one, on earth, was left holding the bag…and all positions basically offset??? Wtf? Why create the derivatives in the first place if no one is at risk? This just does not make sense to me.This is really turning into a cat and mouse game, and I’m afraid at the end of the day a lot of hedge fund investors will find a burning bag of sh-t on their front porch! Happy Halloween!

  7. Elaine Meinel Supkis   October 31, 2008 at 10:10 pm

    This guy is NUTS!!!! We just saw not only a 91% loss in a derivatives swap meet, AIG is now gulping down well over $140 billion in just THREE WEEKS and not at the end of this swap of derivative failures for US taxpayer dollars!This is UNPRECEDENTED.On the other hand, the entire collapse of the G7 banking system is not due to derivatives. The Derivatives Beast may be eating up all the major banks in the G7 stellar complex but the real reason ‘liquidity’ dried up was due to the sudden unwinding of the Japanese carry trade! Even Bloomberg news admitted that most of the world’s monetary expansion of the last 10 years has been nearly entirely due to the Japanese carry trade!And I used to argue here at RGE about this. You guys always talked and talked about China and I would say, ‘What about Japan and their weak yen and 0% central banking?’ And people would tell me to shut up.Well, write a story about that! Or come to my news service, Culture of Life News at

  8. Frustrated by the ignorant   November 7, 2008 at 10:19 am

    Why would you expect to understand how this works unless you are a CDS trader? People spend years learning how these products trade – how could you possibly expect to understand just by reading the misinformation on the internet? I don’t expect to know how to perform heart surgery just because I hear that it’s out there. Bottom line is that product worked and the people that do know how it works continue to see value in it. If you really care – go find a CDS trader and get them to explain how the product works to you. Get a clue.

  9. office2010   June 27, 2011 at 2:40 am

    This Zox Pro review will reveal what Zox Pro is concerning – and it will highlight the attributes I liked