reduces the likelihood of knock-on failures by requiring the participants to post margin, and by loss sharing among other clearinghouse members

TO BE NOTED: From Shadow Bankers:

"Mitigating Counterparty Credit Risk in OTC Markets: The Basics Jump to Comments

By John Kiff*

A central counterparty (CCP) reduces systemic counterparty credit risk by applying multilateral netting. This post discusses key tools of over-the-counter (OTC) counterparty credit risk mitigation, including netting and the collateralization of residual net exposures, and explains how a CCP reduces systemic counterparty risks. A follow-up post by one of my IMF colleagues (Jodi Scarlata) will delve deeper into the particulars of CCPs for credit default swaps.

An OTC contract is exposed to counterparty default risk prior to the contract’s expiration while it has a positive replacement value. In the absence of bilateral closeout netting, the maximum loss to a defaulted counterparty is equal to the sum of the individual contracts’ positive replacement values. The figure below shows two bilateral contracts. A owes B $5 on one contract, and is owed $10 from B on the second one. A faces a $10 loss if B defaults. This all assumes that the counterparties have signed a master agreement with the appropriate closeout provisions that covers both transactions. If they had not, B could “cherry pick” A by defaulting on its obligation to pay the $10, but insisting that A still pay the $5. In this case, A loses $15.

Closeout netting aggregates all exposures between the counterparties, under a default, and contracts with negative values can be used to offset those with positive values. Hence, the total exposure associated with all contracts covered by the particular master agreement is reduced to the maximum of the sum of the replacement values of all the contracts and zero. A loses $5 if B defaults. The exposure can be further reduced by requiring counterparties to post collateral (cash and highly-rated liquid securities) against outstanding exposures, usually based on the previous day’s valuations.

For more detail on OTC derivative collateral and netting practice see Bliss and Kaufmans’ “derivatives and systemic risk” paper. For surveys of OTC derivative counterparty credit risk exposure management practices, including collateral policies, see “new developments in clearing and settlement arrangements for OTC derivatives” by the Bank for International Settlements Committee on Payment and Settlement Systems, and “counterparty credit exposure among major derivatives dealers” by the International Swaps and Derivatives Association. Best practice guides can be found in the 2005 and 2008 reports by the Counterparty Risk Management Policy Group.

The second figure shows contracts across four counterparties, all of whom have bilateral closeout netting master agreements with each other applies. The numbers on the arrows indicate the net bilateral flow (A, B, C and D, clockwise from the top left corner), and the subscripted “E” indicates the maximum counterparty exposure for the counterparty. Thus, E_D = $10, because both A and B owe D $5. Each counterparty faces a maximum counterparty default-related loss of either $5 or $10. C loses $10 if both A and D fail, and D is vulnerable to the simultaneous default of A and B. Hence, A and B should each provision against $5 of potential counterparty credit losses, and C and D should each provision for $10, for a total of $30, even though the maximum potential loss among all four is only $10.

Multilateral netting, typically operationalized via “tear-up” or “compression” operations that eliminate redundant contracts, reduces both individual and system counterparty credit risk. In this case, it could eliminate four contracts, and eliminate all A’s and B’s counterparty credit risk exposure, and leave C and D with $5 of maximum potential individual losses. The third figure shows the two possible post-netting configurations. The leftmost configuration eliminates the circular B → A → C → B flow, and replaces the B → D → C flow with a more direct B → C flow. The rightmost configuration just needs to eliminate the circular B → A → D → C flow. Using such tearup operations, TriOptima’s TriReduce service eliminated about $30 trillion notional of credit default swap contracts in 2008.

A sound CCP takes the multilateral netting principle a step further, and reduces the likelihood of knock-on failures by requiring the participants to post margin, and by loss sharing among other clearinghouse members. Other typical arrangements include capital funds comprised of clearing member contributions and accumulated profi ts and transaction fee rebates. All of this will be covered in more detail by Jodi, but see also Bliss and Steigerwalds’ “derivatives clearing and settlement: A comparison of central counterparties and alternative structures”).

—————————————————————

* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management."

"But there are lots of other things that credit default swaps are useful for."

Felix Salmon comes to the defense of CDSs. There's something strange about this constant focus on the products, and not on the people:

"John Dizard wants to kill off the entire CDS market. It does no good, he says, and quite a lot of harm, and we'd all be better off without it.

I disagree. Dizard says there are only "three possible defences for treating the CDS market as a going concern"; in fact, there are more than that, and he misses out the big one, which is that the CDS market has allowed investors, for the first time ever, to hedge their credit exposure. Yes, there's a downside to that -- which is that it becomes easier to simply buy credit protection than to do the hard work of fundamental credit analysis. But CDS by their nature are more liquid than bonds, and it will always be easier to buy credit protection than to sell a bond."

I'm not sure why insurance on mortgages and bonds is inherently indefensible. It seems sensible to me. Buying CDSs for other reasons than mimicking bonds bothers me, but only in the sense that I wouldn't personally come near them because they're risky, and more like a bet. All I ask is that buyers be clearly and truthfully explained the risks in buying them. That's it.

"What's more, CDS prices are a much better indication of credit risk than bond spreads are, for many reasons including the tax treatment of bond coupons and the fact that many bonds simply don't trade. In other words, not only are they more liquid, they're also more transparent. These are good things."

This seems true to me in theory, but I'd like to see more information on how these differences work out in practice.

"But Dizard doesn't concentrate on simple things like liquidity and transparency. Instead, he talks about CDS providing "support for capital raising", which was never something it was designed or even really used for. The whole point of credit default swaps is that they're derivatives: they're not cash instruments to be used for raising capital."

This is something I talked about on Derivative Dribble. Some people understand bonds because they're essentially loans for capital, but don't see the sense in investments that look like side bets.

"Dizard does have a good point that as spreads have widened, banks have seen increasing amounts of money tied up in CDS collateral. That's a concern, and it's a good reason to work hard on compression, netting, and rehypothecation. It's not a reason to kill the CDS market outright."

In other words, ways to free capital for other uses. However, I'd worry about this possibly lowering capital on these investments right now.

"Dizard's other big point, however, eludes me:

Price discovery is a useful economic function; that is the rationale for commodities markets. But CDS are derivative instruments, whose price is "discovered" these days as a function of equity volatility, since buying equity puts is one way to dynamically hedge the illiquid legacy books...
At high levels of default risk and equity volatility, if you hedge the one with the other you get frantic, self-defeating activity.

I'm not sure I understand this, but Dizard seems to be saying that there's a lot of capital-structure arbitrage going on: people hedging equity positions in the CDS market, and vice-versa. That's a strategy which has blown up quite consistently since the summer of 2007, and it tends to require quite a lot of leverage, so I'd be surprised if it was a major factor today. But even if it is, I still don't see why it means the CDS market should be abolished."

I actually don't understand the point at all. It sounds like a weird trading strategy, at best.

"I do understand, however, what Dizard is saying here:

If the default rates implied in investment grade CDS spreads were to occur, the only economic activity would be court-supervised reorganisation. The CDS market has been preventing efficient price discovery.

He's wrong. I just had a long conversation with Kai Gilkes of CreditSights, who confirmed for me that it's pretty much impossible, in this market, to back out implied default rates from CDS spreads. There are so many technical factors in the market, so many reasons beyond expected default that people are buying protection on certain credits, that it's impossible to isolate expected default probabilities. So I don't know what implied default rates Dizard is using, but I do know that they're unreliable to the point of uselessness, since right now CDS spreads tell us precisely nothing about expected default rates.

So yes, if you try to use CDS spreads as a guide to default probabilities, you're not going to get very far. But there are lots of other things that credit default swaps are useful for. So let's not abolish the entire market quite yet."

That's correct. Here's my comment:

Posted: Dec 09 2008 3:30pm ET

I too believe that CDSs can be useful. As to spreads on many bonds right now, the question is whether or not they are moved more by panic than clear analysis of a company's fundamentals. Right now, there's so much uncertainty, that it must contribute as well.

The real question is do you believe that these spreads are accurately predicting default rates, or simply overshooting in our current crisis.

James Grant had a good piece in the FT about default rates recently I believe.

By DonthelibertarianDemocrat

Report Abuse

Felix also posted a couple replies:

"Posted: Dec 09 2008 3:20pm ET

My point is that you need to combine default probabilities with an opaque risk-aversion function to get credit risk prices. We can use CDS prices as a great way of pricing risk. But how much of that is default probabilities and how much is something else, we don't know.

By Felix"

"Posted: Dec 10 2008 09:39am ET

Let me try one more time: the *price* of credit risk is a *very* important number in financial markets, and the CDS market is the best way of discovering it. The implied probability of default, on the other hand, is basically bullshit, and neither the CDS market nor anything else is going to help you very much on that front.

As for Whalen, his numbers make zero sense to me, sorry, and I think the reason that he's unable to explain them in English is that they just make zero sense, period. I do like the way though that when he stuns an audience into silence, he takes their lack of questions as assent.

By Felix"