Monsters Under the Bed

Story Highlights:

• A suspected contributor to the financial crisis is the global credit default swap (CDS) market—a shadow derivative market largely unregulated and lacking in public disclosure.
• For the first time, extensive CDS market data will be available to the public in a weekly updated report by the Depository Trust & Clearing Corporation.
• Investors worry over this issue incessantly. However, the report shows overall net exposure to CDS is far lower than was widely feared and risk was reasonably well spread.

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Monsters are childhood phenomena conjured by the imagination when the unknown lurks. They're seen in shadows, imagined from sounds, and often described using estimates and exaggerations. They are, in short, fears fashioned into images—powerful, overwhelming things that will surely attack in the night.

As adults, we rarely use monsters to explain our fears of the unknown, yet our fears are no less prone to estimation and exaggeration. Perhaps it's no wonder then that a suspected contributor to the recent financial crisis is the global credit default swap (CDS) market—a shadow derivative market that's largely unregulated and lacking in public disclosure.

CDS contracts are purchased by holders of debt to insure against the event of that debt defaulting. The contracts originated as a way for banks to protect themselves from loan losses. Over the last decade, the global CDS market grew 100-fold to an estimated $55 trillion and now comprises contracts against the debt of companies, governments, individuals, indexes, and asset-backed securities.

Despite its size and extent, the CDS market remained mostly opaque. Contracts were traded privately between two parties and weren't processed through a clearinghouse. This made it almost impossible for public assessment of how much was being bought and sold and who was involved. As risks of default escalated with the financial crisis, investors increasingly flocked to the CDS market, and in turn, spurred speculations over default and increased worries about the ability of contract sellers to cover the unknown amount of outstanding contracts.

For the first time, extensive CDS market data is being made publicly available. The Depository Trust & Clearing Corporation (DTCC) was recently sanctioned to act as a clearinghouse for a large portion of CDS trades, and on Tuesday, released data covering an estimated 90% of the global CDS market.

Like the exaggerated fears of monsters under the bed, the report showed overall net exposure to CDS is far lower than was widely perceived and reasonably well spread out. The DTCC report showed $33.6 trillion worth of gross outstanding CDS contracts, at a net notional value (the maximum potential net payout upon default and after the cancellation of overlapping transactions) of $3.2 trillion. These amounts are far less than the estimated $57.9 trillion.

Though some worry CDSs for certain entities are overwhelmingly skewed, signaling investors think these debts have high chances of default, the gross outstanding CDSs are split against hundreds of corporate single issuers (40.4%), various indexes and index tranches (54.2%), governments (5.0%), and individual loan/mortgage-backed securities (0.5%).* Even for those entities with the highest notional values against their debt, it's likely the net exposures are divided among hundreds of participants with relatively small individual exposure. This suggests no single default is likely to cause other major entities to fail.

The DTCC reports (updated on a weekly basis) will imbue a significant degree of transparency to the CDS markets. This transparency may go a long way to reduce misperceptions and alleviate investor concerns regarding the CDS market—finally bringing the CDS market out of the shadows and into the known.

* Source: DTCC