This article appeared in Capital page of The Edge Malaysia, Issue 792, Feb 8-14, 2010.

Understanding Credit Default Swaps: The Rehabilitation of

the CDS
By Jasvin Josen

History details a number of financial crises, and it seems that in every crisis, a new occurrence
appears to have got out of hand and needs to be curbed. The 1929 Crash witnessed commercial
banks recklessly entering the market, making margin loans, trading stocks and other investment
activities. The Glass Steagall Act separated banking sectors and investment houses to prevent banks
from engaging in the stock market with our savings. On the black Monday of 1987, trading of equity
derivatives brought about extreme volatility into the stock market, exacerbating panic. Exchange
rules were tightened with circuit breakers and investment banking activities were separated from
analyst research. The 2008 crisis now sees the CDS that needs restraining and rehabilitating.

In the previous article, lack of oversight on the CDS is largely blamed for the financial market
catastrophe. This article will analyse the regulation atmosphere then and will go on to describe the
rehabilitory efforts being put in by the U.S. (Europe is not far behind). It will also discuss the
potential issues in placing some of the regulations and whether they are foolproof.

No regulation please

People naturally tend to look for holes in the system to find ways to do trades without government
interference. The CDS and CDO markets were growing so fast that regulation was lagging behind. But
it was also developing so lavishly that no one wanted regulators to step in. So market practitioners
avoided new regulation by adapting the slightest directive possible to look compliant.

The Glass-Steagall Act that prevented commercial banks to double as investment banks also
prohibited banks from getting into the insurance business. However in 1999 the Gramm–Leach–
Bliley Act that was passed in the U.S. ended this division. Commercial and investment banking, plus
insurance, came together again allowing mega financial firms like Citigroup to be formed. Then in
2000, a new law, the Commodity Futures Modernization Act stipulated that most OTC derivatives
would not to be regulated as “futures” or “securities”. Instead the major dealers could continue to
have their deals supervised under general “safety and soundness” standards. This made it very
difficult to regulate the CDS.

AIG’s credit derivative deals were not regulated by the Fed or the Securities Exchange Commission;
instead they were supervised by the Office of Thrift Supervision (OTS), a relatively small organisation
that monitors savings and loan associations. The OTS apparently had only one specialist on
insurance1.

Regulation efforts and problems

1
Matt Taibbi, “The Big Takeover”, www.rollingstone.com, Mar 19, 2009
The world is currently conferring and debating on the best way to remedy the circumstances that led
to the financial crisis. While a revamp of regulation is being proposed for the banking industry
world-wide, specific regulation is seen as necessary for the CDS business. Measures are being
deliberated and implemented, but not without problems.

Counterparty Risk and the central counterparty house

The credit market had no public records showing whether protection sellers have the assets to pay
out if a bond defaults. The Fed only supervised commercial banks’ CDS exposures, not of investment
banks or hedge funds, both of which were significant issuers. Hedge funds are said to have written
31% of CDS protection2. Sellers of protection were not required by law to set aside collateral in the
CDS market. While banks ask protection sellers to put up some money when making the trade, there
were no industry standards.

A clearing house acts as the buyer to every seller and seller to every buyer, reducing the risk of a
counterparty defaulting on a transaction. A clearinghouse also provides one location for regulators
to view traders’ positions and prices. But to have a central clearing system, the CDS contract must
be standardised - as such, features like credit event, auction procedures, settlement, coupons, and
effective dates are now being standardised. It is believed that this will enable trade compression
(netting off); which may be inconvenient in the short term but has the potential to make the market
more efficient.

The American Treasury has made specific proposals to trade and clear all “standardised” OTC
derivatives on an exchange. When contracts are not cleared centrally, firms would incur strict
margining and capital charges on their trades. Admittedly, this may ruin the chance of more exotic
OTC species.

But in practise, the implementation by lawmakers seems watered down. Fewer derivatives and
fewer firms seem to be involved. Should oil companies, airlines and fund managers, which routinely
use derivatives for hedging, be in the system too? Hedge funds which are not strictly financial
institutions may squirm out too. Even dealers may find a way with exempted firms (like food
companies) to channel their derivative trades through.

The rules currently focus on single name CDS and indexed CDO (a standard basket of credit names)
only. It is crucial not to miss out bespoke CDOs , e.g. the ones that caused the demise of AIG.

Margin calculation is an issue as well. Margins are calculated from volatility of historical prices.
Customised CDSs and CDOs do not have historical data. Also, imposing strict margins is not
necessarily fool proof. Clients will eventually look for segregated margin accounts.

Exchange Trading Platform

CDS, being privately negotiated contracts had no regulated exchange for prices in the market.
Quotes were sent by banks to investors via e-mails. In 2007, Chicago Mercantile Exchange set up a

2
F. William Engdahl, ” CREDIT DEFAULT SWAPS THE NEXT CRISIS”, Financial Sense Editorials, June 6, 2008
federally regulated, exchange-based market to trade CDS. Apparently it did not work and was
boycotted by banks which preferred to continue trading privately.

Banks dislike exchange-trading platforms because they narrow bid-ask spreads, undermining
profitability. Others rightly argue that only a few OTC derivatives are amenable to exchange trading.
It is like buying a package holiday from a travel agent. Everyone’s holiday is different.

OTC contracts are normally big; a single order could move the market price, creating uncertainty for
traders. Alternatives are being worked out in place of an exchange- to allow broking over the
telephone to continue or use an electronic trading system. But with these, the public arena is again
missed out.

However, standardised CDS exchange with a central counterparty system may attract more players
to the market, who like the idea that it is now so simple. Over time, some other new products may
be created.

Naked CDS trading

Soros insists in his book (The Crash of 2008) that “only those who own the underlying bonds to be
allowed to buy them. This would tame the destructive force and cut the prices of the CDS”.

According to a Barclays Capital Report3 on 9 Feb 2009, the proposed American bill is not clear on
whether naked CDS trading is allowed. “Do participants need to own the underlying?”

Is it possible to limit naked CDS trading? Counterparties would no longer want to sell protection,
even to those that own the bonds, since they probably do not own the reference asset as well and
could not hedge themselves by buying protection from another company.

What next for Malaysia

The above are some of the main aspects of regulations around the CDS that are being ironed out
globally. In the next and final article, I will focus on the prospective CDS in the local market. With the
lessons the world has learnt, we will discuss possible measures to manage the CDS right from the
start.

3
Bradley Rugoff, “CDS Market Changes”, Fixed Income Research, Barclays Capital, Feb 6, 2009