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This paper benefited greatly from comments from Jochen Andritzky, Charles Blitzer, Randall Dodd, Karl Habermeier, Matthew Jones, Laura Kodres, and Manmohan Singh.


To be more precise, the CFMA exempted CDS from various provisions of the Commodities Exchange Act through the “swap exemption” (see section 2(g) of the Act).


The Depository Trust and Clearing Corporation (DTCC) Warehouse Trust Company has applied for a New York State and New York Fed charter.


The net number for a particular reference entity is reflective of the amount of cash (or obligations for physical settlements) required to settle all of the outstanding contracts with a zero percent recovery rate after a credit event. However, such netting ignores contractual differences, such as maturities and differential credit event definitions. In addition, the netting calculation implicitly assumes that all contracts within a counterparty “family” can be legally netted, which may not be the case.


Most CDS transactions were historically “unfunded” (involving no up-front payments by the protection seller), but if counterparty risk is a concern or a credit event is considered very likely, up-front payments and/or collateral may be required. This was traditionally the case for high yield names.


Net notionals are calculated by summing up all the net short (or long) positions by counterparty family. A “family” may be a single account, or multiple accounts of the same or different legal entities, aggregated typically at the holding company or investment manager lever. Net notionals better reflect risk transfer amounts than gross notionals.


Sourced from DTCC as of September 18, 2009.


Bespoke CDS are unique structured credit products that are tailored to client-specific needs and consequently are both difficult to value and largely illiquid. Hence, data on these CDS are not presently collected by DTCC. Various estimates suggest that the DTCC data represent 80–90 percent of the CDS market.


For example, the average confirmation lag for equity derivatives was 9.2 days, and for interest rate derivatives it was 6.8 days. However, OTC equity derivative backlogs have been more difficult to reduce than those on credit derivatives because a smaller proportion of equity derivative transactions are dealer-dealer compared to credit derivative transactions and also tend to be less standardized than credit derivatives.


The operational data is sourced from various editions of ISDA’s Operations Benchmarking Surveys.


See the Testimony Concerning Credit Default Swaps by Erik Sirri, Director, Division of Trading and Markets at the U.S. SEC, before the SEC Before the House Committee on Agriculture, November 20, 2008.


However, for only a few reference entities do net notional amounts of CDS contracts outstanding exceed outstanding deliverable obligations. A recent tabulation by JP Morgan showed that this was generally only the case in situations where there was a paucity of deliverables.


In the worst case, a squeeze on the underlying deliverable instrument, where one party amasses a large portion of the stock of outstanding reference obligations and drives up their prices, could cause price spikes and multiple failures to deliver on the contract by other parties.


The cash-opt in settlement protocol allows counterparties to settle in cash at a price determined in an ISDA auction of the defaulted bonds, or opt to continue to settle their trades with physical delivery of the bonds.


Under the new contracts, trades can still be unwound prior to the auction for those wishing to bypass the auction procedure.


For more detail on the “Big Bang” see Markit (2009a). Another important change was the creation of regional “determination committees” to better formalize the process by which it is determined whether a credit event has occurred, its type and date, plus the setting of specific auction terms, including deliverable obligations. ISDA has created a special one-stop web page for such information ((


Where single-name CDS contracts reference only one entity, index-based CDSs have a set fixed coupon based on the underlying spreads of multiple credits. Every six months the composition of the index is reconstituted and a new contract series trades with the new higher or lower coupon. In addition, CDS on high-yield credits have always traded on an up-front basis plus a fixed 500 basis point annual premium.


In 2006, some dealers tried to introduce annuity swaps as a standalone product to help them to manage annuity risk. However, the product did not offer anything compelling for investors and never took off.


In the example, the protection was bought for 100 basis points per annum plus about two percent of notional upfront, and unwound (or cancelled) in return for a lump sum of eleven percent of notional.


If the trade date was more than 30 days before the first coupon date, the protection buyer paid a short-stub premium on the first payment date. If it is within 30 days of the first payment date, a long-stub premium is paid on the following quarterly payment date.


For example, the deliverable obligations on a four-year contract against a restructuring event would be different from those that are deliverable against a five-year contract (see annex).


For example, rather than trigger an immediate restructuring event, protection buyers may prefer to wait for a possible bankruptcy event, after which the price of the deliverable bonds is even cheaper.


The compression service for portfolios run by Markit and Creditex has already reduced gross notionals by over $1 trillion. TriOptima’s “TriReduce” tearup service eliminated about $30 trillion notional of redundant, mostly index-based multi-name, CDS contracts in 2008, and about $9 trillion in the first half of 2009. According to the DTCC there were about $27 trillion notional of CDS contracts registered in its Trade Information Warehouse on September 18, 2009.


For European CDS, two additional coupons (300 and 750 basis points) have been implemented on an interim basis to facilitate the re-couponing of legacy trades.


Under Basel II, protection that does not include the restructuring event is discounted 40 percent, even though the counterparty risk weight for contracts with regulated CCPs will be zero, versus the 20 percent on a bilateral contract with a high-quality bank.


For European settlements involving restructured obligations there would be one bucket for CDSs with less than 2.5 years to maturity (which would include restructured obligations of up to 5.0 years and non-restructured obligations of up to 2.5 years); a 2.5 to 5.0 year bucket (5.0 and 5.0 years), a 5.0 to 7.5 year bucket (7.5 and 7.5), a 7.5 year+ bucket (10.0 and 10.0); and a “seller” bucket (30.0 and 30.0). For more detail, see Markit (2009b).


Outstanding exchange traded derivatives are less than 20 percent of outstanding OTC derivatives.


NYSE LIFFE is a subsidiary of NYSE Euronext, and Eurex is jointly owned by Deutsche Börse and SIX Swiss Exchange.


The ICE has formed ICE US Trust, LLC as limited purpose bank subject to regulation by the Federal Reserve System and the New York Banking Department. Having received Fed approval on March 4, 2009, and an exemption from the SEC on March 6, 2009, it announced the closure of The Clearing Corporation (that had developed the clearing infrastructure for ICE Trust,) and ICE Trust began clearing some CDX tranches on March 9, 2009. The initial participants in ICE US Trust were include Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, and UBS. The CME has set up a joint venture with Citadel Investment Group called CMDX, which received regulatory approval from the CFTC and Fed in December 2008, and a special exemption from the SEC on March 13. The special SEC exemption was required so that it could use its existing clearing membership structure to clear CDS.


ICE cleared about $3 trillion between March and October 2009 ($2.3 trillion in ICE Trust US and $750 billion in ICE Clear Europe) after which open interest stood at about $300 billion.


Duffie and Zhu (2009) also make the important point that adding a CCP for just CDSs could reduce netting efficiency, and suggest that the optimal solution involves a single CCP that clears CDSs, interest rate swaps, and other OTC derivatives. In fact, Japan may see the launch of an all-encompassing CCP in early 2010. However, Duffie and Zhu (2009) do not address the concentration risk that arises from having only one clearing entity.


Initial margin, the amount required to be collateralized to initiate a position, and variation margin, which accounts for the daily offsetting of losses and gains required to keep the position open, allows for intra-day monitoring and margin posting as well as end-of-day settlement of positions. Variation margin is based on daily mark-to-market pricing; positions are liquidated if variation margin cannot be met.


Cross-margining agreements would enable a CCP to access a defaulting participant’s assets at another CCP. According to ECB(2007), “interoperability means agreeing on common processes, methods, protocols, and networks to enable cooperation between central counterparties at the technical level. This would allow central counterparty clearinghouses worldwide to develop links between eachother.”


In the United States, a bank is either nationally chartered by the Office of the Comptroller of the Currency (OCC), or state-chartered by the specific state banking department.


The MOU was signed on November 13, 2008 as one of a series of initiatives of the President’s Working Group on Financial Markets to strengthen oversight and the infrastructure of the OTC derivatives market.


This amends FASB Statement No. 133. FASB has provided additional guidance on FAS 133 (Accounting for Derivative Instruments and Hedging Activities) to provide more detailed direction in this area.


FAS 161, paragraph A47.


Management’s Discussion and Analysis of Financial Condition.


An imbedded derivative is an implicit or explicit term in a contract, such as a bond, that meets the definition of a derivative even though the entire contract or instrument may not.


The full text of the letter can be found on the New York Fed’s website (


Not all CDS issuances would be destined for clearing and settlement systems—this would only apply to the most liquid issuances.


U.S. Congresswoman Maxine Waters introduced the Credit Default Swap Prohibition Act of 2009, but it seems to have gained no traction. In July 2009, the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009 that would make it “unlawful for any person to enter into a credit default swap unless the person would experience financial loss if an event that is the subject of the credit default swap occurs.” However, the bill includes language that would make the CDS provisions null and void if any other legislation around CDSs or OTC derivatives is passed. In July 2009, In December 2008, the New York insurance department made and then withdrew a similar proposal. More recently, the House Financial Services Committee is considering the Over-the-Counter Derivatives Market Act of 2009, which does not propose banning or recharacterizing CDS transactions.


Prior to putting their operations on hold, in the spring of 2009, LCH.Clearnet cut its fees further by “at least 50 percent” as it revealed an initial 30 percent discount on clearing of four continental European cash equities markets (Financial Times, 2009).


The U.S. Treasury’s “proposed framework” was outlined in a letter from Timothy Geithner to a number of Congressional leaders on May 13, 2009 (


Morgan Stanley apparently forced the Kazakh bank, BTA, into bankruptcy in order to crystallize the value of its CDS contracts on the bank (Buiter, 2009).

Credit Derivatives: Systemic Risks and Policy Options?
Author: Mr. John Kiff, Ms. Jennifer A. Elliott, Mr. Elias G. Kazarian, Ms. Jodi G Scarlata, and Carolyne Spackman