Successful Self-Regulation of the CDS Market

Many politicians argue that letting Wall Street sort out the CDS risk problem itself, without massive government intervention, is like letting foxes regulate their own access to the chicken coop. Nonetheless, in recent years, coordinated efforts between the Federal Reserve Bank of New York and industry participants working through the Operations Management Group have made notable progress in addressing public concerns about the CDS market.

According to the Managed Futures Association, a Washington-based investment industry trade group, some of the recent improvements and systemic risk mitigants that have been successfully accomplished without government regulation have included:

• Reduction by 80% of backlogs of outstanding CDS confirmations since 2005
• Establishment of electronic processes to approve and confirm CDS novations
• Establishment of a trade information repository, the DTCC, to document and record confirmed CDS trades
• Establishment of a successful auction-based mechanism that allows for cash settlement and has been actively employed in 14 credit events, including Fannie Mae, Freddie Mac, and Lehman Brothers
• Reduction of 74% of backlogs of outstanding equity derivative confirmations and 53% of backlogs in interest rate derivative confirmations since 2006

The smooth functioning of the CDS system of protection and risk mitigation during the Lehman bankruptcy is particularly noteworthy, according to Robert Pickel, the longstanding CEO of the ISDA (International Swap Dealers Association), the industry-wide trade body that creates and maintains legal agreements between most of the world’s CDS counterparties.

During the largest bank failure in world history and the largest bankruptcy in US history, the CDS settlement process worked perfectly, Pickel says. “The unwinding of ISDA contracts and the entire derivatives book of Lehman across different products went smoothly despite a lot of consternation to the contrary, and no firm went under as a result. The biggest uncertainty during the process was not at all related to CDSs or other derivatives, but to some issues with prime brokers in the UK accessing their collateral,” he observes.

–Theodore J. Kim, Esq., CFA, FRM, is a New York-based managing director of Smart Cube, an independent global research firm focused on capital markets and investment management.

This article was originally published as a companion piece to "Controlled Dangerous Substances: The CDS Market Goes Straight," which appeared in the Summer 2009 issue of the Investment Professional.