A Step In The Right Direction Against Counter Party Risk

Bloomberg is reporting this morning that some 2,054 entities have signed up to participate in a group which will oversee the credit default swap (CDS) market. CDS are the instruments (amongst others) that got AIG in trouble. Some of the big criticisms of such derivatives is the lack of standardization, oversight and clearing. CDS are not regulated products like stocks, bonds or options, but are are private contracts instead. There can even be disagreement between parties on whether or not a default of the underlying company really occurred.

This is called "counter-party risk"- the risk that the other party to a trade won't pay up when they're supposed to. Anyone who traded or owned securities issued by Lehman knows this all too well. For example, Lehman had several products available to retail as well as institutional investors called ETNs or Exchange Traded Notes. Similar to ETFs (Exchange Traded Funds), ETNs represent a basked of investments and trade to track the value of that basket. ETNs are not actually funds, however. Instead they are notes or obligations by the issuer that the note has the same value as a particular basket or index of assets. Anyone who purchased Lehman ETNs is still waiting to find out what they are worth, if anything.

Counter-party risk is very real and very underappreciated. In fact, people tend to think about counter party risk only when a crisis strikes. Last fall, suddenly everyone was afraid to buy paper from anyone else because who could tell who would go bust next? Yet there are ways to mitigate counter-party risk. One method is to have your counter-party post collateral at certain thresholds. Say you have a contract with a dealer 'D' to pay you if some company 'C' defaults. You could agree in the contract that if said company C gets downgraded to BB or 'junk' status by one of three major ratings agencies, dealer D would have to post say 40% of the potential value in escrow with a third party. If dealer D suddenly can't pay as things get worse, at least 40% of the deal is set aside to fulfill your contract.  This is just one counter-party risk mitigation technique.

Just as important and perhaps more advantageous to all, is the standardization of contracts, terms and events. Abiding by the same rules as the rest of the market, gives participants confidence the contracts will settle correctly. As mentioned earlier, some parties have disagreed on whether a default really occurred. The most recent example is when Fannie and Freddie were siezed by the government. The preferred stock was wiped out, but the bonds are backed by the Treasury; the companies are not bankrupt, but rather in receivership. Naturally, this ambiguous state can be interpretted differently.

As Bloomberg reported, the major participants in CDS have gotten together under the urging of the Fed and agreed on a comittee to determine the status of such events without litigation. As the title suggests, this is the first step towards reducing risk in such derivatives. The next step ought to be a clearinghouse where all contracts are recorded and settled. Clearinghouses prevent double-counting (or more!) of outstanding positions and enforce settlement, trading and other rules which make a market transparent. More on clearinghouses some other time. (Note that CDS represent a fraction of all derivatives outstanding. Much more needs to be done, but this is a step in the right direction for all such markets. They just need to get it done ASAP.)