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?

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