Derivatives trading crackdown begins

Derivatives trading crackdown begins

Banks start talks on bringing order to chaotic derivatives market for credit default swaps

Elena Moya guardian.co.uk,
Tuesday 7 April 2009 16.30 BST Article history

An attempt to bring order to the chaotic, multibillion-pound world of credit derivatives began in London today with moves to standardise contracts in the market.

Banks last year traded about $54tn of credit default swaps (CDSs), contracts that protect investors against the default of a bond or loan, but the global financial crisis triggered the collapse of the market, bringing down AIG, the world's biggest insurer.

The G20 summit in London last week made it a priority to bring order to the market and today specialists from banks including UBS and Morgan Stanley agreed to trade standardised contracts, as well as organise committees that would oversee cases where there was a default.

"The proposed changes provide a means to guarantee greater unanimity of results across positions, add more openness and transparency to the process, and give formal representation to members of the buy-side community," said Markit, a leading provider of data on CDSs.

The London-based firm has also started to publish CDS pricing data on its website. Apart from CDSs on specific corporate loans or bonds, the public can also see the price investors pay to protect themselves against debt issued by sovereign countries such as Britain or the US. The riskier a country is perceived to be, the more expensive its insurance.

"Regulators are very keen to see this being put into place," said David Austin, a director at Markit.

As the unsupervised market grew after 2000, the number of CDSs issued rose well above the number of loans or bonds outstanding, as any bank could issue these insurance products and receive hefty fees for them.

AIG issued large amounts of CDSs on products that contained sub-prime mortgages, and could not honour the payments when they defaulted. It was like selling insurance on a car to five people, even if only one owned the car. If the car crashed, five people claimed the insurance. AIG is now partially nationalised.

With so many CDSs linked to a particular loan or bond, creditors queue to receive payments but some will not be paid because there are more contracts than real lenders. With corporate defaults expected to soar, a better way of dealing with payments after a default is needed.

Standard contracts are seen as a first step towards a central clearing house – a place where all banks contribute collateral to be used as a lifeline in case a bank or institution collapses. At present, banks trade with each other, not through a central house.

The G20 said last week it would push for the creation of centralised clearing houses as a way of improving market confidence. US and European governments are spending billions of pounds to insure the banks' worst assets, or to buy them from their books, in order to restore inter-bank lending and kick-start the economy.

http://www.guardian.co.uk/global/2009/apr/07/derivatives-trading-crackdown