The Big Flaw Of The CDS Big Bang

May 07, 2009

Is the credit default swap Big Bang a setup for another Big Bust?


Is the CDS Big Bang setting us up for another Big Bust? Did we just give billion-dollar matches to people now pouring gas onto over-insured assets? Is anyone out there watching this—or does the thought of reading about credit default swap regulation put people to sleep at their own peril? Wake up ...

On April 8, 2009, the so-called Big Bang Protocol reshaped the CDS market. Its primary intention was to standardize contract terms that encourage greater central clearing and eventually electronic trading. As with most of the regulatory changes implemented or proposed during the credit crisis, the Big Bang's goals were noble but a chain is only as strong as its weakest link, and the creation of the Determinations Committee (DC) brings the CDS chain close to a breaking point.

Few can argue publicly against the need for greater transparency and standardization in the CDS market. Traders remain reluctant to give up fat commissions they have made buying and selling credit protection since 1995 but most understand now that the situation has changed and they must adapt to the new or fade away with the old. Creation of the DC via the Big Bang Protocol is part of the new, supposedly more transparent CDS market, but it instead reinforces the same control structure that brought upon the current mess.

Determining The Real Triggers

Big bankruptcies like those seen with Lehman and Chrysler are not the most common credit events triggering CDS payments. Changes in company ownership, leadership or organizational structure can also be deemed credit events, but understanding which events are triggers and which are not is difficult.

The DC's main goal is to uniformly agree when a credit event has occurred to prevent any litigation or market uncertainty. Not only does the Big Bang create this group, but it also modifies standard CDS documentation for new trades to recognize its omnipotence for all things credit events. More standardization equals less guesswork, which will result in a much clearer market structure, right? In theory, this is true, but the devil is in the details.

Separate DCs will exist in multiple regions with each consisting of 15 voting members comprising 10 sell-side dealers and five buy-side firms. Inclusion of the nondealer buy-side firms is intended to diversify the group and ensure decisions made benefit the market as a whole. Diversified this group is not.

The DC's makeup is identical for each region despite protocol-specified requirements to include two regional dealers. Two regional dealers are in fact included in every DC. However, the dealers deemed regional for one DC are considered global in the others. Furthermore, this group of 15 controls the vast majority of CDS trading globally. Sure the trading strategies and positions of each are different, but all work from the same fundamental base making the decisions undoubtedly biased. Understand that in no way am I questioning the ethics of the DC or any member thereof. But business is business and firm-specific motives will certainly seep into the decision-making process.



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