Legislating the CDS market?

By: ispeculatornew
Date posted: 12.12.2008 (4:00 am) | Write a Comment  (2 Comments)

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The Credit Default Swap had been a market known to very few up untill a few years ago but the recent credit crisis made the market come into the spotlight. It is one of the largest and fastest growing markets in the world, a $15.5 trillion market. A CDS is an insurance on the default of a given bond issuance. the buyer of a CDS will get a payment if the issuer of the bond defaults on an interest or a principal payment. The seller of the CDS or insurance will make the payment.

There are also CDS issued on bond indexes and they have been an important part of the credit market, intially as hedges but as time went by they became an important tool for speculators. Like many more exotic products, CDS started trading as OTC (over the counter) products which was justified as they are highly flexible and no exchange was ready to develop the market.

But over the years, the CDS market has became a lot more standardized and while we probably will never reach a day where all CDS trades can be done on an exchange, there are probably close to 99% of these trades that could be done on an exchange. Why do so? Consider AIG, the largest insurance company of a few months ago. When they got into financial trouble, the US government deemed it could not fail because of its huge exposure on credit default swaps. Why so? Imagine you are any other bank and have many bonds that are insured with CDS trades done with AIG. Suddenly, AIG goes bankrupt and instead of a hedged bond portfolio, your portfolio becomes totally exposed and you can imagine what kind of impact this would have created.

The interest in setting an exchange is that it could function as do futures, so any sellers of credit default swaps would be required to post a margin at the exchange leaving market participants comfortable that they are not at the risk of their trade counterparties failing (counterparty risk) as the exchange would be responsible for this.  Even firms that were reluctant at some point such as Goldman Sachs (GS) are now hoping to move a part of their trades to an exchange, they have estimated they could move over 90% of their trades to such a platform.

“Executives of CME Group Inc. and IntercontinentalExchange Inc. in the U.S., Britain’s LIFFE exchange and Eurex Clearing AG of Germany each assured the House Agriculture Committee that they would provide safe, neutral central structures that would contain risk and manipulation in the market for the swaps.”

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2 Comments

  1. […] out if we should legislate the CDS at Intelligent […]

  2. […] over the next few years in the financial markets, in how some products such as credit default swaps are traded but also in the regulations that hedge funds must comply with… 16 Jan 09 | Uncategorized […]

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