Plain Vanilla Facts Are the Best Flavor for CDS

New York — We at ISDA have been faced with frequent misconceptions regarding the CDS market since problems arose in the European sovereign bond market early in 2010. The misconceptions come from a variety of sources and pop up in newspapers, journals and the speeches of politicians. We thought this week’s derivatiViews might correct these erroneous points, particularly given that sovereign CDS have been much in the news of late.

The misconceptions come in a few different flavors:

Misconception #1: The CDS market is opaque

The most uninformed flavor is that the CDS market is opaque — hardly ISDA’s favorite word — and no one, including regulators, knows how much exposure there might be on any reference entity. (Reference entity is simply the name of the corporation, bank, sovereign or other body on which a credit default swap is written.) This is an easy misconception to correct.

Information on virtually every trade in the CDS marketplace is found in DTCC’s trade repository. Data on the 1,000 reference entities with the largest amount of CDS outstanding are readily available on the DTCC website by going to OTC Derivatives, then Warehouse CDS Data and then Section I, Table 6. The tables show, among other data, the Reference Name, Gross Notional, Net Notional and Number of Contracts. The information is there for all to see, including regulators.

Misconception #2: Gross Notionals = risk outstanding

A second flavor is a misconception about Gross Notionals, with people pointing to Gross Notionals to claim that the CDS market drives or overly influences the cash market. It might be useful to look at an example. We have chosen New Zealand, a sovereign far removed from the happenings in Europe. According to figures from Table 6, CDS data on New Zealand is as follows:

Gross Notional:             $3,077,220,480
Net Notional:                 $576,217,440
Number of Contracts:    354

In this case, there are $3 billion of CDS outstanding but a large number of the contracts offset one another, resulting in $576 million of net exposure. Here’s how this works: If Dealer 1 sells $20 million of protection to Investor A, Dealer 1 will have a $20 million net and gross position. Assume time passes and Dealer 1 buys $20 million of protection from Investor B. New Zealand’s Gross Notionals will be increased by $20 million. But Dealer 1 now has a zero Net Notional position and New Zealand’s total Net Notionals remain $20 million – the positions of Investor B. Gross Notionals say very little about risk but quite a lot about liquidity.

Misconception #3: Net Notionals = the market’s net position

The third flavor is a misconception of how Net Notionals are calculated, with people claiming that while New Zealand’s Net Notionals may be $576 million, individual institutions may have written or bought far more protection than that. Net Notionals are not the net position of the market. The market must have a zero net position, as for every buyer of protection, there is a seller. Buyers or sellers are both dealers and non-dealers.

Net Notional, as defined by DTCC, “is the sum of the net protection bought by net buyers (or equivalently net protection sold by net sellers).” If there is only one net buyer of protection on New Zealand, he will have bought $576 million. If there are a hundred net buyers of protection, the sum of their bought positions will be $576 million.

Misconception #4: Regulators can’t see the risk exposures

The last flavor refers to claims that regulators do not know how much risk their banks have in CDS. This misconception is simplest to refute. DTCC provides regulators with information about the positions of each of the banks subject to its jurisdiction. Trade repositories like DTCC’s CDS repository were created to give these supervisors information about the marketplace and about their banks.

You may have guessed our secret motive for derivatiViews this week. The more people know about the wealth of information available, the less they will call the CDS market “opaque.” Aren’t you tired of hearing or seeing that word?

Preserving Netting Efficiency

New York — One of ISDA’s core beliefs is in the power of close-out netting, which enables counterparties to reduce their credit risk exposure to each other. No single tool is more effective in delivering safe, efficient OTC derivative markets.

That’s why the Association is concerned about the effect of legislative provisions contained in the Dodd-Frank Act.  These provisions could have serious adverse effects on the efficiency of netting. And less efficient derivative markets could have the effect of exacerbating system risk. No one has done the analysis of the extent to which the benefits of clearing are offset by less efficient bilateral netting. Where is netting inefficiency being introduced? The following are a few examples, and we suspect there are many more:

  • DFA Section 716.The so-called “push-out” provision forces banks active across product areas to create a new company for equity, commodity and certain credit derivatives.
  • Clearinghouse proliferation.By all accounts, clearinghouses will abound—by product type and by geographic area. Clearing has huge potential for risk reduction through multilateral netting, but a proliferation of clearinghouses will make it harder to achieve that potential as transactions are moved from bilateral arrangements to a multitude of clearinghouses. ISDA is fully supportive of the greater use of clearinghouses, particularly when netting and compression can be aggressively pursued for cleared trades. But as we move into this new cleared world, we must be attuned not just to its promise, but to its limitations.
  • Breaking up hedged sets.A potentially risk increasing effect of trades moving to clearing is where the trade to be cleared provides a hedge for a trade that cannot be cleared. The bilateral trade that remains and the cleared trade that is moved to the clearing house are no longer netted under an ISDA Master Agreement.
  • Legacy trades vs. new trades.ISDA has generally taken the view that new regulations should only apply to new trades, and that legacy trades should reflect the terms and regulatory environment at the time the trade was done. But proposals regarding margin for uncleared trades could create a dilemma: apply the new rules to all transactions (both existing and new) under one master or create two masters, one for the old, uncollateralized trades and one for the new, collateralized ones.
  • Extraterritoriality. Then, there is the issue that has reared its head in issue after issue—the applicability of national rules to global participants in global markets. We will address the many facets of this issue in an upcoming Views, but depending on how these issues are addressed, strong incentives may be created for booking business in a multitude of entities, a sure recipe for netting inefficiency.

How does ISDA work to maximize netting efficiency in this new world? First, we remain focused on spreading the gospel of the benefits of netting, as evidenced by legislation in ­­­38 jurisdictions, and the 55 opinions that provide the backbone of the ISDA Master Agreement (Members can see all those opinions by logging in to the ISDA Members Portal). In this regard, we continue to urge European regulators to take up the cause of a netting directive. Second, we help regulators understand the exposures of derivatives market participants as they face a more fragmented and less efficient netting environment. Third, we pursue ways, through documentation, regulation or otherwise, to facilitate netting across entities and platforms.

Netting remains a key part of ISDA’s mandate. We believe, in short, that if you undermine netting, you undermine the safety and efficiency of markets.

We encourage members to email us at with their reactions to each View and to suggest new issues that might benefit from analysis and comment. 

Expediting G-20 Commitments

NEW YORK — Welcome to derivatiViews, a new weekly feature of the website which we will also email to our membership. It’s intended to be an informal comment on important derivatives issues. We hope it will be informative and easy to read, make good common sense — and prove to be controversial at times.  Whatever their topic or tone, Views will be consistent with our long-held commitment to make the derivatives market safer and more efficient. In this first edition, we focus on global regulatory reform.

Going back to 2009 in Pittsburgh, the G-20 pledged to work together on several initiatives to foster safe, robust financial markets.  Clearinghouses would be used to clear standardized derivatives and such contracts would be executed on exchanges or electronic trading platforms where appropriate. All contracts would be reported to trade repositories. Implementation would be monitored to improve transparency, mitigate systemic risk and protect against market abuse.

It’s important to note that these pledges did not mandate that all execution go onto exchanges or exchange like facilities. Rather, the G-20 stated that execution should go onto electronic platforms “where appropriate.” Unfortunately, legislation has been passed that goes beyond the G-20 commitments. The Dodd Frank Act (DFA) has mandated that swaps that must be cleared must also be executed on swap execution facilities provided they are capable of being traded. This “G-20 plus” portion of DFA  has meant that rules for an entire marketplace need to be fashioned from scratch and, amazingly, put into place within a year — at the same time as the G-20 safety and soundness commitments must also be put into place.

ISDA believes that clearing improves the safety of the marketplace, provided the clearinghouses themselves are conservatively structured, managed and regulated.  Reporting trades to regulators through trade repositories also improves the market’s safety.   These safety and soundness issues are the key objectives of the G-20 commitments and they ought to be put in place before additional changes are made and mandates imposed. We realize, of course, that legislation has been passed and laws must be implemented. But let us look at what has occurred.  Legislatures and regulators globally are all devising separate laws and rules to cover all the G-20 commitments at the same time. The result may be a plethora of clearinghouses and trade repositories, overlapping jurisdictional claims, and, now, a host of market structure issues that have little, if anything, to do with safety and soundness. The result has been an inordinate amount of effort by regulators and market participants and insufficient progress on safety and soundness issues. We wrote recently to US Treasury Secretary Geithner and EC Internal Markets Commissioner Barnier raising just these points.

We think there’s a better way.  Global regulators should first agree on rules for clearing and clearinghouses and for trade repositories and focus on no other tasks until this is done. It might be a better way to make the markets safer and more efficient, something ISDA has been working on for 26 years.

What do you think about this issue?  We encourage members to email us at with their reactions to each View and to suggest new issues that might benefit from analysis and comment.  Finally, while Connie or Bob will author most pieces, we do envision having guests write Views from time to time.