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Credit Default Swap Concerns
With the credit derivatives market now surpassing $5 trillion, it is difficult to continue to call it a niche market. But it is a unique and complex market that carries greater exposure to operational risk as volumes grow. A key success factor will be controlled and sustainable growth. That means a reduced dependency on a phone-based interdealer market, an increased reliance on technology and straight through processing initiatives, and eliminating the lag time between when the actual transaction takes place and when the paperwork is processed.
A Credit default swap is an agreement by one party to accept a premium at regular intervals in return for making a larger payment if a specific company defaults, goes bankrupt or suffers a negative credit event. Pricing transparency and trade processing are the major hot button issues for credit default swaps.
Most players in this market are heavily regulated entities, but the newer players, hedge funds, are not as tightly monitored. And hedge funds are entering this market with intensity, and have actually changed the dynamics of the market.
Several regulatory agencies and policymaking entities like the International Swaps and Derivatives Association (ISDA) are extremely proactive and continually issuing recommendations and protocols. Most of the issues revolve around the inefficiencies in the back office. For example:
- Obtaining pricing information is complex and an immense data gathering effort for various electronic platforms. Dealers need these utilities to independently verify their positions for their internal auditors as well as to give their clients an independent source of data so they can mark-to-market their own positions. Having the data available increases pricing transparency for buy- and sell-side institutions. It eliminates a potential conflict of interest between clients and their dealer counterparties, as well as between dealers who might have the incentive to quote an unfavorable price that will reflect badly on a competitor. It is estimated that about 40% of the data is rejected every day.
- The large numbers of outstanding confirmations plagues the industry. For interdealer trades, the seller of the protection produces the confirmation and sends it to the buyer of the protection. The economic terms of the deal may be correct, but other details may be in dispute. If details aren't agreed to, the trade can't be confirmed and the trade is stuck in limbo until one side yields, or the two parties agree on a third one. A recent ISDA survey indicated a reduction in the backlog of confirmations was reduced from 17.8 days to 11.6 days, and the industry experienced an increase in the automation of confirmations from 24% to 40%. More effort is needed in this area to sustain growth.
- Some market participants assign their side of a trade to another institution without the consent of the original counterparty to the trade. This practice has the potential to distort the ability of individual institutions to effectively monitor and control their counterparty credit exposures. ISDA has put the confirmation of assignments (also known as novations) front and center with the recent issuance of the 2005 Novation Protocol.
The credit derivatives industry is experiencing growing pains common to exponential growth. But no one is expecting a meltdown or the need to launch rescue missions. Mostly because players, regulators and policymakers are all addressing the issues proactively.
Debt & Derivatives is SS&C's comprehensive financial application software designed to process and analyze all activities related to your derivative and debt portfolios, including credit default swaps. The Credit Default Swap module of Debt & Derivatives is specifically designed to value and account for credit default swap (CDS) contracts. The module supports single-name CDS, CDS indices, and full or partial terminations/assignments. SS&C continues to work toward enhancing Debt & Derivatives to make sure it keeps abreast of the changing environment.
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This article first appeared in the 1/20/2006 edition of our Insurance eBriefing.
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