>CREDIT DEFAULT SWAPS (DEUTSCHE BANK)

The use of credit default swaps (CDSs) has become increasingly popular over time. Between 2002 and 2007, gross notional amounts outstanding grew from below USD 2 trillion to nearly USD 60 trillion.

The recent crisis has revealed several shortcomings in CDS market practices and structure. Lack of information on the whereabouts of open positions as well as on the extent of economic risk borne by the financial sector are partly to blame for the heavy reactions observed during the crisis. In addition, management of counterparty risk has proved insufficient, as has in some instances the settlement of contracts following a credit event.

Heading towards a more stable system

Past problems should not distract from the potential benefits of these instruments. In particular, CDSs help complete markets, as they provide an effective means to hedge and trade credit risk. CDSs allow financial institutions to better manage their exposures, and investors benefit from an enhanced investment universe. In addition, CDS spreads provide a valuable market-based assessment of credit conditions.

Currently, the CDS market is transforming into a more stable system. Various private-led measures are being put in place that help enhance market transparency and mitigate operational and systemic risk. In particular, central counterparties have started to operate, which will eventually lead to an improved management of individual as well as system-wide risks.

Meanwhile, regulation should be designed with caution and be restricted to averting clear market failures. Regulators should avoid choking the market for bespoke credit derivatives, as many end-users are highly dependent on tailormade solutions. From an analytical point of view, it has yet to be established under which conditions CDS trading – as opposed to hedging – does more harm than good, and whether central trading – in addition to central clearing – is required to achieve systemic stability.

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