By Ananda Radhakrishnan From the beginning of U.S. futures trading in the mid-1800s until recently, regulated futures exchanges offered the primary means by which commercial entities could manage their physical market price risks. During the 1980s, however, financial institutions began to develop non-exchange-traded derivatives contracts that offered similar risk management benefits. In 1981, the World Bank and IBM entered into what has become known as a currency swap. The swap essentially involved a loan of Swiss francs by IBM to the World Bank and the loan of U.S. dollars by the World Bank to IBM.
The motivation for the transaction was the ability of each party to borrow the funds they were loaning more cheaply than the counterparty, thus reducing overall funding costs for both parties. This structure of swapping cash flows ultimately served as the template for swaps on any number of financial assets and commodities.
The development of the OTC swap industry is related to the exchange-traded futures and options industry in that a swap agreement can function as a competitor or complement to futures and option contracts. Market participants often use swap agreements because they offer the ability to customize contracts to match particular hedging or price exposure needs. Conversely, futures markets typically involve standardized contracts that, while often traded in very liquid markets, may not precisely meet the needs of a particular hedger or speculator.
The OTC swap market has grown significantly because, for many financial entities, the OTC derivatives products offered by swap dealers have distinct advantages relative to futures contracts.
Yet, these OTC swap transactions are largely unregulated. With respect to the CFTC, the Commodity Exchange Act (CEA) excludes most OTC financial derivatives, including CDS, from its regulatory and enforcement jurisdiction.
Credit Default Swaps
The current financial crisis is requiring policymakers to rethink the existing approach to market regulation and oversight. Many observers have singled out OTC credit derivatives, including CDS, as needing greater scrutiny and transparency.
OTC credit derivatives emerged in the mid-1990s as a means for Wall Street financial institutions to buy insurance against defaults on corporate obligations. Specifically, OTC credit derivatives are bilateral off-exchange instruments that allow one party (the protection buyer) to transfer credit-related risks associated with the actual or synthetic ownership of a “reference asset” to another party (the protection seller) for a price.The reference asset associated with an OTC credit derivative may be a corporate debt obligation (such as a bond or a bank loan), a sovereign debt obligation, an assetbacked security (such as commercial mortgage-backed securities), or any other obligation or debt.
Credit derivatives transfer the credit risks attendant to the actual or synthetic ownership of a reference debt obligation. The most common credit derivative product is the CDS. Under a CDS, the protection seller promises to compensate the protection buyer for the economic loss associated with a material decline in the value of a reference asset that is triggered by the occurrence of a pre-determined “credit event,” such as a filing for bankruptcy or default on a debt payment by the issuer of the reference asset. In some CDS contracts, the protection buyer pays the protection seller a “periodic premium” for the protection. If a triggering credit event occurs, then the protection buyer would receive a full lump-sum payment that is some fraction of the par value of the reference asset, to compensate the buyer for the asset’s devaluation. In turn, the protection buyer would deliver the devalued asset to the protection seller. The estimated notional amount of CDS transactions has nearly doubled every year since 2001 to reach an estimated peak of $62 trillion in 2007, before receding 12 percent to $54.6 trillion as of June 30, 2008.
In all likelihood, this number somewhat overstates the actual size of the CDS market because many traders hold offsetting positions that have not been netted against each other. Nevertheless, the size of total CDS positions is substantial.
The Benefits of Clearing of OTC CDS Transactions Recent events have uncovered the risks that certain CDS transactions pose to the financial system. American International Group, an insurance company, reportedly issued CDS transactions covering more than $440 billion in bonds, leaving it with obligations that it could not cover in the current market conditions. This CDS exposure factored into the Federal Reserve’s decision to provide an $85 billion conditioned loan to the ailing company to prevent its failure and a possible contagion event in the broader economy. Clearly, there are major risks associated with these products that need further review.
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