Contingent Credit Default Swaps
In the past year contingent credit default swaps (CCDS) have gained significant market visibility. These contracts provide default protection for an uncertain amount of exposure (the contingency implicit in the name) based on the fair market value of a reference swap. As I point out in my October Risk Analysis column, it is somewhat ironic that banks have long been unable to assume such credit risk as part of a third party contract when they would happily assume it by undertaking the actual swap directly with the reference counterparty. While this new contract may be a helpful tool in some cases, I argue that it has significant limitations. (See: http://www3.sungard.com/SunGardFinancial/menus/documents/risk_managers/200710%20No%20Silver%20Bullet.pdf )
What do readers think about the future of CCDS and do you see some variation on this structure that would be more effective? Are there possible portfolio applications, as opposed to single counterparty hedges, that could be addressed by a structure that references multiple counterparties?
October 25th, 2007 at 11:00 am
David,
Interesting article. As the primary interbank broker of CCDS I am always encouraged to see our product getting attention, good or bad.
However, I would like to update you on a couple of develpments in the market. Firstly, the vanilla CCDS documentation structure, as published by ISDA, does allow for the inclusion of multiple reference swaps and several trades of this type have occurred. Secondly, that a new variation on CCDS is evolving. That is the portfolio or Index CCDS. This new product allows banks to hedge the systemic correlation risks of their portfolio. ICAP has commission a document for this purpose that I would be happy to provide to anyone that is interested. This confirm template has not yet been published by ISDA, but the process to do that has been initiated. I can easliy be found on Bloomberg if you or any of your readers wish to discuss this further.
Bill Mertens
ICAP PLC
Head of Credit Hybrids
October 26th, 2007 at 2:33 am
I appreciate Bill Mertens input. It is useful to know that the CCDS market is migrating into deals with multiple reference swaps. That said, I shudder to think of the back office headaches this will create if such trades have to be confirmed and booked manually. There are enough problems in booking deals directly with clients, so having to book multiple deals as reference portfolios would present worrying operational challenges if this market develops significant volume. Assuming sufficient personnel were allocated to keep the operational risk under control, the significant back office processing cost per trade would have to be factored into the spread on each transaction.
The ultimate solution, of course, relates to another ISDA initiative, namely the specification and standardization of FpML as an XML protocol for electronic description and transmission of swap details. If multiple client swaps could be transmitted from dealer to dealer by simply checking them off on a deal list, it would represent a significant breakthrough for the CCDS market. This would allow the prospective seller of contingent credit protection to receive the underlying portfolio and perform appropriate simulations to determine the magnitude and the market drivers of the contingent credit exposure. This would provide a sound basis for deriving a price quote. It also would allow automated confirmation and booking of the transaction, with the XML files being stored as evidence of the agreed underlying portfolio in case of a dispute.
With such functionality in place I can see the CCDS market exploding, since the obstacle of massive and error prone manual processing would be removed. Until then, however, I think the serious operational obstacles involved will present a serious drag on its growth. The good news is that this may present the dealer community with the significant financial incentive it needs to embrace the costs required for wide-spread adoption and deployment of FpML. Needless to say, this would have the very favorable knock-on effect of a general reduction in operational risk in the back office.
October 26th, 2007 at 5:07 am
David,
You are right on target with your statement that operational obstacles are holding back growth in this market.
It was initially anticipated that trading would focus on even benchmark maturities and at the money genaric swaps and banks could accept the basis risk to the actual swaps in their portfolio. Pricing and booking would be quick and trivial. However, what has evolved in the years that we have been doing this is that most hedgers are only interested in transacting very detailed swap structures leaving them no basis to their actual risk. The result has been that it requires a significant investment of time on the part of a CCDS provider to model up each deal and then tie out with the broker or another member of his team. Average time from first inquiry to completed trade is in the range of several weeks as a result. Traders are also inhibited by the time they know will be spent post trade on booking and documentation.
ICAP obviously has a vested interest in doing what ever it can to reduce transaction costs for it’s clients. As an example we organized the first working groups to standardize the confirmation of CCDS trades.
I personally am not familiar with the FpML initiative that you mentioned, although I’m sure someone at ICAP is actively engaged in that process. I will investigate that and see if it can be useful in the CCDS market. Thank you for the pointer.
Bill Mertens