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Credit Derivatives in 2009 & Current Developments

d-fine Risk Management Breakfast Tower 42

Tim Brunne Credit Strategist


London, 25 September 2009

Introductory Remarks

During the crisis, credit derivatives "enjoyed" particular attention by politicians, regulators and the media (as well as securitizations and structured credits). Regulation, processing, standardization and central clearing of OTC derivative markets have been debated for years. CDS sometimes became a sort of scapegoat for the financial market crisis (Buffet, Soros, Dinallo, Petersen, etc.). But not the instruments failed, investment strategies did. Naked CDS long; opaque market; central counterparty clearing The demise of Bear Stearns, Lehman Brothers and, last but not least, the bailout of AIG (Financial Products) put the industry under intense pressure to improve the resilience of the market with respect to counterparty risks. Some not-so-constructive proposals are not yet entirely off the table, but much has changed during the past 11 months "Financial regulatory overhaul", "Resilience of OTC derivatives market", ISDA, ICE

AGENDA

GLOBAL OTC DERIVATIVES VERY SHORT COURSE ON CDS CORPORATE AND SOVEREIGN CDS TRADING CREDITS DURING THE CRISIS CDS CENTRAL COUNTERPARTIES

From more than 100% annual growth to a 50% decline

CDS outstanding volumes (ISDA semi-annual primary member survey)

total CDS outstandings (USD tn eq.)

70 ISDA primary member survey 60 50 40 30 20 10 0 Jun 01 Jun 02 Jun 03 Jun 04 Jun 05 Jun 06 survey effective-date Jun 07 Jun 08 Jun 09

Source: ISDA, UniCredit Research

Shrinking global CDS volumes indicate change in 1H08

CDS outstanding volumes (BIS semi-annual G10 survey data)


notional amount outstanding (USD tn eq.) 60 Multi-name instruments 50 Single-name instruments 40 30 20 10 0 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08
Source: BIS, UniCredit Research

Gross market value surges to USD 5.7tn at YE 2008

Global CDS gross market values (BIS semi-annual survey data)


6 gross market value (USD tn eq.) Multi-name instruments 5 Single-name instruments 4 3 2 1 0 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08
Source: BIS, UniCredit Research

CDS gross market value grows at fastest pace

Global OTC derivatives gross market values (BIS semi-annual survey data)
6 Credit default swaps gross market value (USD tn) 5 4 3 2 1 0 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08
Source: BIS, UniCredit Research

24 FX contracts Interest rate contracts (right scale) 16 12 8 4 0 20 gross market value (USD tn) (IR)

DTCC covers about 80% of the market

ISDA semi-annual primary member survey compared to DTCC TIW data


total CDS outstandings (ISDA) 60 total CDS notional (USD tn eq.) 50 40 30 20 10 0 2007-12-28 total gross notional (DTCC; CDS, indices & index tranches) 60 50 40 30 20 10 0 2010-01-01

2008-05-23

2008-10-17 2009-03-13 end-of-week date

2009-08-07

Source: ISDA, DTCC, UniCredit Research

AGENDA

GLOBAL OTC DERIVATIVES VERY SHORT COURSE ON CDS CORPORATE AND SOVEREIGN CDS TRADING CREDITS DURING THE CRISIS CDS CENTRAL COUNTERPARTIES

Single-name CDS The most simple contract

(A) No default event


Premium Payments Premium Leg

Effective Date

Maturity Date

Default Leg

(B) Default event


Accrued Premium at Default Premium Leg

Effective Date Default Payment (1 Recovery)

Maturity Date Default Leg

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Index CDS The cornerstone of CDS liquidity

Example with two default events


Reduced premium payments Premium leg Effective date Maturity date Default leg

Default payment (1 Recovery)/125

Reference notional
Reference notional will be reduced by 1/125

Effective date

Maturity date

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Credit derivatives referencing corporate and sovereign credit risk

Risk type

Single-name Credit Default Swaps (CDS) Digital Default Swaps (DDS) Forward CDS Constant Maturity CDS

Portfolio CDS Indices (iTraxx, ), Futures Bespoke Linear Baskets Dynamic Leverage Note (e.g. CPDO) CPPI Structures First-to-Default (FTD) Baskets Index Tranches (iTraxx, CDX) (Bespoke) Coll. Debt Obl. (CDO) CDO^2 Equity Tranches, POETs, Tranchelets

Linear Spread Risk

Default Correl.

Spread Volatility Hybrid Risk

Credit Default Swaptions

CD Swaptions, Variance Swaps Options on Futures / TR Locks First-to-Trigger Baskets on EDS Collateralized Fund Obligations (CFO)

Hybrid Capital (Financials/Non-Fin.) Sub CDS, Equity Default Swaps Capital Structure Arbitrage

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AGENDA

GLOBAL OTC DERIVATIVES VERY SHORT COURSE ON CDS CORPORATE AND SOVEREIGN CDS TRADING CREDITS DURING THE CRISIS CDS CENTRAL COUNTERPARTIES

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Outstanding CDS volumes continue to shrink in 2009

Aggregated CDS gross volume (DTCC trade information warehouse, weekly data)
35 CDS gross volume (USD tn eq.) Index CDS 30 25 20 15 10 5 Single-name CDS Index tranches

0 2008-10-31

2009-01-16

2009-04-03 2009-06-19 end-of-week date

2009-09-04

Source: DTCC, UniCredit Research

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Dealer vs. customer Who buys CDS?

Global CDS breakdown by CDS type, CDS buyer and seller (DTCC)

100% (perc.) total gross notional (USD tn) 0.135 95% 1.190 90% 1.403 85% 80% 1.301 75% 70% 65% Index (8.4 USD tn) Single (15.6 USD tn) Tranche (3.1 USD tn) CDS type (total gross volume)
Customer(protection buyer) - Customer(investor) Dealer(protection buyer) - Customer(investor) Customer(protection buyer) - Dealer(investor) Dealer(protection buyer) - Dealer(investor)

1.240 0.104

Source: DTCC, UniCredit Research; effective date: 18 September 2009

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Investment-grade CDS indices are most liquidly traded

Gross notional: Break-down by index/index tranche family


gross notional volume (USD tn eq.) 5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 tranche volume (est.) (week ending 11-Sep-09) index volume (est.) (week ending 11-Sep-09)

Source: DTCC, UniCredit Research; effective date: 11 September 2009

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iT ra xx i T Eu iT rax rop ra x x x Eu e M iT Eu rop ain iT rax rop e F ra x E e in xx u Hi Eu rop Vo ro e l pe XO ot he C r D CD X. X N .N A. A I C G.H .IG D C X. V O D N L X. A N .H A Y C ot D he X. r EM in di ce s LC iT DX ra . N xx A AB Le X/ vX C M B ot iT X/ he r TA r C ax B D xo X S th in er di ce s

Index-CDS standardization facilitates trade compression

Aggregated index CDS gross volume (DTCC TIW, weekly data)


15 gross notional (index CDS) (LS) gross notional volume (USD tn eq.) 14 13 12 170 11 150 10 9 8 7 2008-10-31 130 110 90 2009-01-02 2009-03-06 2009-05-08 2009-07-10 end-of-week date 2009-09-11 number of contracts (RS) 210 190 number of contracts (thsd) 230

Source: DTCC, UniCredit Research

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The fingerprints of index-portfolio compression trades

New-trade volumes of iTraxx Europe Main, index & tranched-index (not complete*)
400 iTraxx Main new trades (ind./tr.) (EUR bn) 350 300 250 200 150 100 50 0 2009-01-02 S1 S2 S3 S4 S5 S6 S7 S8 S9 S 10 S 11

2009-03-06

2009-05-08 2009-07-10 end-of-week date

2009-09-11

Source: DTCC, UniCredit Research; *DTCC only releases data for a particular index series if a minimum activity level is reached within the respective week.

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During the crisis sovereign and financial CDS gained in importance

Single-name corporate and sovereign CDS: breakdown by sector and CDS seller
gross volume (USD tn eq.) 4 3 2 1 0 Customer (week ending 18-Sep-2009) Dealer (week ending 18-Sep-2009)

Fi na hn n ol In cia og du ls C y & stri on T a su ele ls C on m c su er om m G er oo Se ds H rvi Ba ealt ces si h C c M are at e O rial O il th & s er G as co rp Util or iti at es So e C ve D re S ig ns & St at es
Source: DTCC, UniCredit Research; effective date: 18 September 2009

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Te c

C M BS R Lo MB an S O CD th er S C D S

iBoxx Corporates credit risk Cash outweighs CDS

bond notional amount (EUR bn)

200 iBoxx Financials 150 100 50 0 AAA AA+ AA AAA+ A ABBB+ BBB BBB- BB+ BB BBiBoxx Non-Financials

50 CDS net notional (EUR bn) 40 30 20 10 0 AAA AA+

iBoxx Financials

iBoxx Non-Financials

AA

AA-

A+

A-

BBB+ BBB BBB- BB+

BB

BB-

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Source: Markit, DTCC, UniCredit Research; effective date 24 July 2009; CDS volumes for iBoxx-DTCC entities and single-name CDS only; iBoxx-DTCC entities are iBoxx issuers which are also listed among the most important single-name CDS reference entities by the DTCC TIW

AGENDA

GLOBAL OTC DERIVATIVES VERY SHORT COURSE ON CDS CORPORATE AND SOVEREIGN CDS TRADING CREDITS DURING THE CRISIS CDS CENTRAL COUNTERPARTIES

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CDS market only became illiquid in 4Q08

iTraxx Europe index skew (index fair value vs. traded spread)
300 250 CDS spread (bp) 200 150 100 50 0 Sep-07 Dec-07 Mar-08
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Fair Value

iTraxx Main 5Y

Jun-08 Sep-08 Dec-08 Mar-09

Jun-09 Sep-09

Are single-name CDS for trading or hedging?

Aggregate single-name contract volume by maturity


3.5 70

gross notional volume (USD tn eq.)

Gross notional (LS) (week ending 18-Sep-2009)


3 60 50 40 30 20 10 0

2.5 2 1.5 1 0.5 0

2009

2014

2019 2024 2029 year of scheduled maturity

2034

Source: DTCC, UniCredit Research

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Avg. notional (USD mn eq.)

Mean contract size (RS)

Single-name CDS market activity: Staying liquid vs. cash-hedging

Aggregate weekly single-name gross vol. changes by year of scheduled termination


100 80 weekly gross notional change (USD bn) 60 40 20 0 -20 -40 -60 -80 -100 2009 2009-01-09 2009-01-23 2009-02-06 2009-02-20 2009-03-06 2009-03-20 2009-04-10 2010 2009-01-16 2009-01-30 2009-02-13 2009-02-27 2009-03-13 2009-04-03

2011 2012 CDS maturity

2013

2014

Source: DTCC, UniCredit Research.

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Single-name CDS market activity: 5-year is king

Aggregate weekly single-name gross vol. changes by year of scheduled termination


100

weekly gross notional change (USD bn)

50

-50 2009-01-09 -100 2009-01-23 2009-02-06 -150 2009-02-20 2009-03-06 -200 2009-03-20 2009-04-10 -250 2009 2010 2011 2012 2013 2014 2015 CDS maturity 2016 2017 2018 2019 2009-01-16 2009-01-30 2009-02-13 2009-02-27 2009-03-13 2009-04-03

Source: DTCC, UniCredit Research.

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AGENDA

GLOBAL OTC DERIVATIVES VERY SHORT COURSE ON CDS CORPORATE AND SOVEREIGN CDS TRADING CREDITS DURING THE CRISIS CDS CENTRAL COUNTERPARTIES

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CDS central counterparty A simple notion that bears subtleties


CDS central counterparty

Purely bilateral trading and settlement

Central counterparty clearing of CDS

Major CDS Dealer

Central Counterpart

Major CDS Dealer

A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction. It also provides one location for regulators to gain insight into traders positions (and possibly their prices). Assuming the existence of 2 CCPs and around 20 major dealers, the number of bilateral relationships is reduced from 190 to 40 by using the CCP CDS settlement model. The schematic view depicted above hides the complexities that are associated with switching from one regime to the other: Credit event settlement, efficient and prudent margining/risk management, trading model.
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ICE Trust US cleared USD 2.1tn CDS to date

240 180 120 60 0 2009-03-27

Number of cleared CDX contracts (RS)

2.4 1.8 1.2 0.6

2009-05-01

2009-06-05

2009-07-10

2009-08-14

0 2009-09-18

160 120 80 40 0 2009-03-27

2.4 1.8 1.2 0.6

2009-05-01

2009-06-05

2009-07-10

2009-08-14

0 2009-09-18

Source: ICE Trust US, ICE Clear Europe, UniCredit Research

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wkly contracts (thsd)

wkly gross notional (EUR bn)

200

Cleared iTraxx Europe CDS (EUR bn) Number of cleared iTraxx contracts (RS)

wkly contracts (thsd)

wkly gross notional (USD bn)

300

Cleared CDX.NA CDS (USD bn)

On-the-run iTraxx Europe avg weekly turnover exceeds EUR 40bn

Weekly turnover in the most liquid euro-denominated CDS: iTraxx Europe S11
CDS-notional wkly turnover (EUR bn) 80 40 0 -40 -80 iTraxx Europe S11 (new trades) -120 iTraxx Europe S11 (trade terminations) 2009-05-01 2009-06-05 2009-07-10 end-of-week date 2009-08-14 2009-09-18

-160 2009-03-27

Source: DTCC, UniCredit Research

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On-the-run iTraxx Europe avg weekly clearing volume is EUR 20bn

Cleared volume of untranched iTraxx Europe Main Series 11 (ICE Clear Europe)
wkly volume of cleared CDS (EUR bn) 80 40 0 iTraxx Europe S11 (ICE-cleared volume) -40 -80 -120 -160 2009-03-20

2009-04-24

2009-05-29 2009-07-03 end-of-week date

2009-08-07

2009-09-11

Source: ICE Trust US, ICE Clear Europe, UniCredit Research

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"G15" committed to clearing 80% of historic "eligible" CDS by Oct.

CDX.NA.IG CDX.NA.IG.HVOL CDX.NA.HY iTraxx Europe iTraxx Europe HiVol iTraxx Europe Crossover 0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 2600 2800

S8

S9

S10

S11

S12

DTCC total gross CDS volume (USD bn)

CDX.NA.IG CDX.NA.IG.HVOL CDX.NA.HY iTraxx Europe iTraxx Europe HiVol iTraxx Europe Crossover 0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 2600 2800

S8

S9

S10

S11

S12

cumulative cleared CDS notional (USD bn)

Source: DTCC, ICE Trust US, ICE Clear Europe, UniCredit Research; effective date is 18 September 2009

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How many single-name CDS will be offered by CCPs?


CDS central clearing

Top-500 CDS references (indices, single-names) represent ~80% of gross volume


cumulative volume (single-name, CDX.NA and iTraxx CDS) 100% gross notional (% of total volume) 27 gross notional (USD tn equiv.) 24 80% 21 18 15 40% 12 9 20% 6 3 0% 0 0 250 500 750 1000 1250 no. of ref. names / underlying indices (sorted by gross notional)

60%

Source: DTCC, UniCredit Research; effective date 3 April 2009

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Buy-side access to central clearing will be launched in October 09

Non-dealers get access to ICE via account seggregation, separating the customers' margin payments and positions from those of their dealers. Who is eligible to become an ordinary clearing member? How many clearing houses will emerge for CDS? Will regulators sanction bilateral trades among non-dealers?
Source: ECB, UniCredit Research

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Your contacts

UniCredit Group Markets & Investment Banking Bayerische Hypo- und Vereinsbank AG Dr. Tim Brunne Senior Credit Strategist Credit Strategy & Structured Credit Research UniCredit Research Tel. +49 89 378 13521 Fax +49 89 378 33 13521 tim.brunne@unicreditgroup.de

Some of our publications: Global Credit Research Daily Credit Briefing (8:45 AM CET) Euro Credit Pilot (monthly) Credit Strategy & Structured Credit Research Credit Strategy Update, Strategy View, Strategy Flash Credit Strategy Special Securitization Market Watch

Imprint Markets & Investment Banking Bayerische Hypo- und Vereinsbank AG Arabellastrasse 12 D-81925 Munich

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