Credit Default Swaps: Danger Passing?

The amount outstanding has fallen 25%. Exchanges are creating more transparent ways to trade them. Are we finally getting a handle on these derivatives?

By Ben Levisohn

Tick. Tick. Tick. That's the sound of the credit-default-swap time bomb counting down to financial Armageddon, if the critics of the now-famous financial derivatives are to be believed. Designed to insure bondholders against losses from issuer defaults, credit default swaps have been largely invisible, untraceable, and unchecked for nearly three decades. That opaqueness is adding to the uncertainty in the market, an environment that has banks hoarding cash and refusing to lend.

But as the world waits breathlessly for the blow-up, something strange is happening: Recent news reports and data on CDS seem to suggest that banks and securities dealers may be getting a handle on the situation.

For starters, the International Swaps & Derivatives Assn. (ISDA), an industry trade group, announced on Oct. 31 that $25 trillion in notional value—the face amount of the debt insured by the instruments—has been eliminated from the CDS market since the beginning of the year. That brings the total down to $46.95 trillion. (The number does not include new trades since July 1, 2008.) That's a 25% decline from the market's $62.2 trillion peak, meaning that CDS investors have fewer open contracts on the market.

Greater Transparency Ahead

At the same time, the Depository Trust & Clearing Corp., which collects credit-default-swap data, announced on Oct. 31 that it will begin releasing market information weekly, including trading volume.

While it's a far cry from the transparency we're used to in the equity markets, this kind of information has been sorely lacking in the CDS market. The resulting murkiness contributed to fears about companies' CDS exposure, especially after the government bailout of American International Group (AIG). The added info will give everyone, including the general public, a better understanding of what's happening in the market.

Another nettlesome feature of CDS is also being addressed: the lack of a centralized place to clear trades. Today, credit default swaps are simply contracts between two parties. If one party can't pay up, then the other is just out of luck. Regulators, however, continue to push for a central clearinghouse, which would provide money-back guarantees in case one party goes belly-up.

Reducing Counterparty Risk

When you conduct business with a clearinghouse acting as a counterparty, "you don't have to worry whether the person you're trading with goes bankrupt," says Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim (SWIM). Proposals for clearinghouses from the Chicago Mercantile Exchange, the Intercontinental Exchange (ICE), Eurex, and NYSE Euronext (NYX) were to have been submitted to the U.S. Treasury Dept. on Oct. 31. These proposals, Treasury says, will ultimately make counterparty risk—the risk that the other side of the CDS contract will be unable to pay up—a thing of the past.

So, is it time to stop worrying and heed the advice of those who tell us the crisis is past? Not quite.

Let's start with that pesky notional number. At $46.95 trillion, it's enormous. And it's what everyone focuses on, partially because in the muddy informational waters of CDS, it's all we have. Beginning Nov. 4, the Depository Trust & Clearing Corp. will begin breaking down the notional amounts of CDS outstanding by index and company for the first time. This will give interested parties a better sense of what's actually happening in the marketplace.

Is Risk Exaggerated?

ISDA and others have long insisted, and continue to insist, that the notional amount, that $46.95 trillion, is not the amount that's actually at risk.