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Why haven't we banned CDS yet?
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. seems obvious we need to

http://www.ft.com/cms/s/0/7b56f5b2-24a3-11df-8be0-00144feab49a.html

Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss.

The whole idea of modern financial products is to replicate the payment streams of other, more traditional instruments, while offering better conditions. Selling a CDS is like buying a bond. Buying a CDS is a way of shorting a bond – or of insuring against its default. But that does not change the fact that once you strip away the complex technical machinery, you end up with a product that offers insurance – even though it is a lot more versatile than a standard insurance contract.

....argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber. A further stated objection to a ban is that it would be difficult to police. There is no question that a ban of a complex product, such as a CDS, involves technical complexities that commentators like myself probably underestimate. It is conceivable, for example, that the industry might quickly find a legal way round such a ban. Then again, we would not consider legalising bank robberies on the grounds that it is difficult to catch the robber.

So why are we so cautious? From conversations with regulators and law-makers, I suspect they are not always familiar with those products, to put it kindly, and that they may be afraid of regulating something they do not understand. They understand, or think they do, what a hedge fund is. Restricting hedge funds is something they can sell to their electorates. Hedge funds were not at the centre of the crisis, but they are a politically expedient target. Banning products with ugly acronyms that nobody understands seems like unnecessarily hard work.

http://www.brookings.edu/opinions/1999/0520useconomics_mayer.aspx
Unfortunately, these "over the counter" derivatives—created, sold and serviced behind closed doors by consenting adults who don't tell anybody what they're doing—are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall. These instruments are creations of mathematics, and within its premises mathematics yields certainty. But in real life, as Justice Oliver Wendell Holmes wrote, "certainty generally is an illusion." The derivatives dealers' demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.

Banks and supervisors have a lot of trouble accounting for these instruments. If the bank owns the loans and securities it is swapping, it will own them again when the swap expires, which argues that capital should continue to be allocated against the principal. If it doesn't own them, then the transaction is simply a bet on price movements that does not acquire or dispose of an asset, and can be carried off the balance sheet at a much lower capital charge. In June 1997, the Fed ruled that banks could take all such transactions off the balance sheet, making them virtually cost-free to banks—especially if the swap partner is another bank and qualifies for the 80% reduction in capital requirements given to interbank loans by the rules of the Bank for International Settlements.

Why are such derivatives dangerous? The one lesson history teaches in the financial markets is that there will come a day unlike any other day. At this point the participants would like to say all bets are off, but in fact the bets have been placed and cannot be changed. The leverage that once multiplied income will now devastate principal.

The banking supervisors have not begun to control the buildup of leverage on the derivatives chassis. Indeed, Federal Reserve Chairman Alan Greenspan has argued that the mathematicians are improving their formulas to make the business less risky. But the more security the math seems to give, the greater the risk on the day the highly improbable happens. Eighty years ago Frank Knight, arguably the greatest American economist ever, wrote that economists did not always make clear "the approximate character of their conclusions, as descriptions of tendency only." In theoretical mechanics, perpetual motion was possible; in real life it was not. "Policies must fail, and fail disastrously, which are based on perpetual motion reasoning without the recognition that it is such," Knight wrote.

so why arent puts / calls illegal?

you also forget..for each person that buys protection, there is a seller. this article makes it seem like there are only one sided bets being placed.

Stock Options have been around fro some time and have not been shown to be harmful. On the other hand, swaps(i'm most inclined to give vanilla interest rate variety a pass) have not been shown to reduce systemic risk and have been shown to be very destablizing to the U.S. and world economy. Interst Rate and Currency swaps could potentially be tamed by trading on centralized exchange and using a clearing house. CDS actually creates more bad securities than the original reference pool. Volatility is increased which is not a desirable trait, unless the goal is to facilitate gambling and day trading.

Greenspan would differ with you...but hey what does he know.

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Corn Futures are not the same as Credit default swaps. Corn futures bear no resemblance to insurance contracts and have strict position limits. Banning cds would not impair global credit markets.

http://www.cmegroup.com/trading/commodities/files/Spec_Limits_and_Hedge_Fund_Exemptions_070708.pdf

And the argument that banning cds would IMPARI bond markets? This ignores the huge cost to the tax-payer in the AIG bail-out. It's the opposite, non-banning CDS would impair the credit markets.

Even the argument that CDS provides pricing informatino is false. CDS prices does not translate well into default risk. All the movement is on the short end. It's a huge convexity play.

http://www.nakedcapitalism.com/2010/03/so-why-hasnt-the-credit-default-swaps-casino-been-shut-down.html

But perhaps more important, the idea that CDS have legitimate uses is questionable. They are used to hedge credit risk (sometimes) yet their pricing, per Bloomberg or any of the common commercial models, price CDS based on volatility, which is not based on any assessment of the underlying credit. So the idea that the pricing reflects default risk is spurious; indeed, CDS failed abysmally in predicting financial firm default risk during the crisis (Lehman was a particularly vivid illustration). But they serve to perpetuate the erosion of proper credit analysis (why bother if you can just lay off the risk?).

the whole thing is basically a big (unregulated) casino, one which however can impair millions of pensions, retirements and life savings, not to mention have the potential to bring the whole country down!

Bucket shop trading.

lemmings

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I am 100% certain I know a LOT more about CDS (and futures) then you.

with all due respect. this phrase is the worst basis of an argument.

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we mock what we do not understand

Uh...no, marco. See, e.g., Axis powers in WWII, NY governors of late, NBC's handling of late night programming, professional athletes who torture animals. Mocking something, finding something destructive, unacceptable, in need of change, does not by definition mean one doesn't understand it.

And jason, perhaps you care to comment on Warren Buffett's advice: "Don't ask the barber whether you need a haircut." Relying on those who do CDSs as the final arbiters of whether we need them or if the way business is done with them should be changed strikes me as absurd.

hah. good point.

riversider...people that do the best credit analysis all play in the cds market. its here to stay.

I see nothing wrong with someonee doing credit analysis to determine a mispriced CDS and acting on it. I agree the market appears here to stay. I still believe the market does more harm than good in its present form and a good argument exists to ban it. We banned bucket shop trading for many years so it could be done. Probelm is banks make too much money ripping off their clients to voluntarily agree to stop.

Its not about a mispriced cds spread. credit analysis is done on a company and then you can express your view on the company via cds or cash. cds is just another tool used by the street. also happens to be the tool use by the peopel who do the most homework.

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WB's whole premise is to buy what you know and buy what you are familiar with/like (coke, see's candy, etc)--he may in fact have some people on his staff who are basically in charge of hedging his book, but i would never even come close to labelling WB as anywhere near an active derivatives player

Don't misunderstand me. I do not think Goldman is "evil." Nor do I think they are "good." They are a bank. I don't think Greece was duped. They knew what they were doing and blaming the bankers is sort of simplistic. I'm just saying, to expect that someone who works on CDSs and makes a living doing so to give an opinion opinion about them is pretty silly. As surely as you have information and views worth considering, you must admit there are reasonable perfectly intelligent and knowledgeable people who have alternative views.

'i do derivatives all day'

sounds like he's heavily involved

apologies: in my last post "opinion opinion" should read "objective opinion"

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My take on this is that CDS trading is highly profitable at the dealer level. There's a great deal of anecdotal evidence that it has harmed the greater economy and cost the tax payer a neat sum not forgetting it increased financial leverage in the system. The arguments for cds trading seem to be two...
1) that its similar to other derivatives
2) it provides pricing information on the underlying

Both arguments are false.

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not to mention a cost effective way to short credit and in some cases the only way to short credit. Pimco was in the news today going long sovereign credit via cds...go figure

What is the benefit to the capital markets? Why do we need a "cost effective" way to to short credit?

Its expensive, not only difficult to short a corporate bond. CDS eliminates all the operational difficulty.

Marco, I agree with your statement, I just don't see why the capital markets need this?

I can go with shorting stocks which adds liquidity. I don't see CDS increasing reducing spreads on the corporate, sovereign or mortgage debt. I don't see it providing pricing information. Pricing information is from supply and demand and from buyers doing old fashioned credit analysis. CDS prices is more about volatility plays.

So how does institutions having a chepa way to short credit help companies raise capital or add liquidity to the markets?

its not about the cap markets. thats a different arena. this about taking and managing risk. you need to separate primary from secondary markets.

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Great article in Vanity Fair
First how Wall Street mispriced CDS, then realized they had no one to cover their risk with and stories of mysterious power failures when clients wanted positions bought back.

http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004?printable=true

most of you are missing the main argument (most, not all)...the dispute is not about whether trading cds is risky, a good way/the only way to hedge credit risk, whether you should have to own the underlying (well this is kind of part of it), or whether it is a main factor in why our economy is where it is today--the point is that it is completely unregulated

jason exhausted the list of derivatives that came to his mind, but his whole argument is flawed--all futures and options are traded on an exchange--this means they are regulated by the exchange, the clearing houses, counterparties are not essentially blind, and there is transparency to the various regulating agencies--cds are subject to none of this

slap these on an exchange, and the credit world takes a huge turn

Jamba, I like the idea of an exchange. The chief argument in favor is price discovery. The concern about exchange trading is that most contracts would not have sufficient volume. This is why we need to focus on standard plain vanilla contracts and limit specialization. The exchanges do this all the time when they decide on which oil contracts they will support, etc.

If we put CDS on exchanges. At least regulators could enforce position limits, which is a step..

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What AIG did was NOT post any collateral of margin for all the CDS they were writing.
The flaw here is the volatility smile. When the market moves there's just not enough colleral in the world to post, which IS what happened with AIG. Yes , CDS allows trading desks to make a lot of money. Unlike orange juice futures, we're not matching risk takers with risk givers. In CDS the amount of risk created is multiples of the original risk.

jason you really need to get off of your back office high horse, and stop referring to investopedia.com or whereever you are getting the fuel for your banter, but you really sound like an idiot

you basically just repeated everything i said re: the advantages of being listed on an exchange--margin, clearing, etc--so thanks for reinforcing my point

i careleslly inserted the 'all' which you clearly pointed out, but your point is rather moot--you can trade anything OTC--wine futures, box office futures, etc. this does not mean that this is the arena with the best liquidity, or plain and simply the market favored by those not investing solely in a specific asset class

The argument tht CDS is vaulable becaue it creates more ways for a trading desk to make money and off-set it's exposure, is akin to a casino justifying adding a new table. and/or having one of their best card palyers playing the opposite hand across the street.

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i read this forums b/c i have a keen interest in nyc real estate/am looking to purchase in the somewhat near future...and i for some reason decide to poke my head into these forums because i think they sometimes offer interesting discussion (i usually dont because my career is in the financial markets)...but there always seems to be one person, like jason, who thinks he knows it all, despite having probably never traded a single credit default swap in his life

after reading his comments i think i'll refrain from even taking part in a constructive converstaion....so i thank you jason for reminding me why i usually dont comment here...good luck hedging your greek exposure with NDFS

jason is giving cold hard industry facts. riversider spews academic opinion.

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As for you riversider - no, CDS is a zero sum game. They do not multiply risk, they move it around. For every bank or hedge fund that had to pay for the default of GM or Lehman or Iceland, andother bank or hedge fund received the EXACT SAME AMOUNT. So net-net, $1B in CDS obligations will result in say 10 companies paying $1B and ten companies receiving $1B

Incorrect the reference security may be $1,000,000 but multiples of that amount can be created with CDS increasing the overall risk. The amount of risky securities because of CDS is more than without.

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dude stop tooting your own horn...just because you are familiar with how cds settle/are booked by counterparties does not make you by any means an expert on cds (or even knowledgeable)--i have a friend who works at one of the biggest bonds funds on the street (works middle office), and he could talk you under the table. he's got all the terminology in the world, yet he couldnt hedge 1/100th of their book

i bet you could get a lot out of that class yourself--its supposed to show you how to actually use these swaps, not the operational perspective of settling them

The idea that longs net out the shorts and therefore no additional risk is created is absurd.

The fact that you've doubled, trippled or qadrupled the people net long a credit is destablizing. The only way it gets reduced is if people long credit enter into offsetting trades and close out positions.

riversider...for every buy, there is a sell.. up until exchange clearing came into effect recently, all cds were bilateral agreements..one person sold and the other person bought protection. so yes, everything was offsetting.

Marco, the fact that a buy is offset with a sell, works from the trading desk perspective but not from a macro perspective. If the number of long contracts that must be honored grows, then we have that many more participants who are at risk for making large payments. The fact that positions are netted does not equate with less systemic risk.

Every long credit position that AIG entered into had another part short the same credit.
It's only when a party that is long, enters into another short that the position truly nets.

this is my last attempt...there are 2 parties to every contract...the buyer and seller...one wins and one loses. its really that simple. aig lost because all they did was sell (go long credit) protection...the banks won because they bought ( got short credit) protection. just like in the article you posted earlier about the guy that shorted subprime.. he kept going around trying to find someone to sell him protection...one party is short, the other is long.

Sorry, your thinking single trading desk exposure.
there's a difference between
one long and one offsetting short
one thousand longs with one thousand shorts.
In the latter there are one thousand desks that have to cough up margin or pay out.

http://www.rice.edu/energy/publications/docs/Flemming_ImpactEnergyDerivativesCrudeOilMarket.pdf
It is well known that derivative securities provide economic benefits. The key attribute of these securities is their leverage (i.e., for a fraction of the cost of buying the underlying asset, they create a price exposure similar to that of physical ownership). As a result, they provide an efficient means of offsetting exposures among hedgers or transferring risk from hedgers to speculators. In addition, derivatives promote information dissemination and price discovery. The leverage and low trading costs in these markets attract speculators, and as their presence increases, so does the amount of information impounded into the market price. These effects ultimately influence the underlying commodity price through arbitrage activity, leading to a more broadly based market in which the current price corresponds more closely to its true value. Because this price influences production, storage, and consumption decisions, derivatives markets contribute to the efficient allocation of resources in the economy.
Nonetheless, the tightened cross-market linkages that result from derivatives trading also fuel a common public and regulatory perception that derivatives generate or exacerbate volatility in the underlying asset market. These concerns are often voiced in the context of their "destabilizing" effects around major declines in the market. Following the 1987 stock market crash, for example, John Shad, former chairman of the Securities and Exchange Commission argued, "Futures and options are the tail wagging the dog. They have escalated the leverage and volatility of the markets to precipitous, unacceptable levels" (Wall Street Journal, 1988). This concern has led to studies commissioned by the
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http://www.ft.com/cms/s/0/237e6572-2bde-11df-8033-00144feabdc0,s01=1.html

A leading US financial regulator on Tuesday called for the prices of derivatives trades to be disclosed in the same way as stock prices, saying only large Wall Street banks benefited from the current lack of transparency.

“The only parties that benefit from a lack of transparency are Wall Street dealers,” Mr Gensler told a New York derivatives conference. “Right now we have a dealer-dominated world, and that nearly drove us off a cliff.”

Mr Gensler, a former Goldman Sachs executive, said: “To promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms.” He also called for explicit regulation of derivatives dealers and the use of clearing for standard OTC derivatives

Theo Lubke, head of markets infrastructure division at the Federal Reserve Bank of New York, said “post-trade transparency” was an important priority. He said the recent uncertainty around the trading in credit default swaps on Greece highlighted the importance of greater transparency.

“The lack of good knowledge by regulators [about OTC derivatives] is not a tenable long-term equilibrium,” he said.

IF swaps were cars the dealers would argue that cars shouldn't have sticker prices.

jason, marco, you guys are wrong. Riversider is correct. Yes, the transactions are zero sum game, but if the counterparties on the losing side of the deal do not have the capital to cover, systemic risk is increased. The banks increased risks tremendously, and their CDS hedges didn't reduce that risk because the counterparties (mostly AIG) didn't have adequate capital to cover. The systemic risk was increased to unsustainable levels using CDS.

Furthermore. The experience of 1987 and portfolio insurance is yet another example of a derivative increasing systemic risk. Every institution sold futures in a declining market. Today there is near universla agreemetn that this increased risk, not reduced it.

http://www.youtube.com/watch?v=_UXC6Xnt8bg

Frank Partnoy explains why the banks are wrong on CDS and says why the notional value of swaps is the correct way to view exposure.

While I do see some flaws on this argument, I agree about the different asymmetric risk profiles of long vs short. Anyway food for thought...

http://rajivsethi.blogspot.com/2010/03/on-asymmetry-reflexivity-and-sovereign.html

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract...

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

http://www.ritholtz.com/blog/2010/03/time-to-regulate-derivatives/

What is it about derivatives that makes otherwise rational humans become so damned stupid? There is no need to over-complicate this; a rather simple series of steps can be undertaken to bring the most dangerous of derivatives out of the shadows and into light of day.

Radical derivative deregulation had a bastard birth: On the eve of a holiday break, Texas Senator Phil Graham attached a budget bill rider titled the Commodity Futures Modernization Act of 2000. This was done at the behest of his wife Wendy, who was a member of the Board of Directors of Enron.

What the CFMA did was create a unique financial product. Derivatives and Swaps entered a world where they were treated very differently from all other financial products. Stocks, bonds, options, futures all follow specific rules. Securitized derivative products (collaterallized paper such as CDOs, CMOs, CLOs, etc.) and Credit Default Swaps (CDSs) do not.

Consider for example these characteristics of most financial instruments:

-They trade on an exchange;
-Participants have sufficient capital to engage in trading;
-Counter-parties disclosure is known (at the least to the exchange)
-Potential future payments require capital reserves to meet obligations;
-The full amount of traded instruments is transparently disclosed;
-There is a regulator in charge of insuring the above rules are followed.

Derivatives had none of those. Indeed, the CFMA specifically exempted derivatives not only from these items, but added they were exempt from state insurance regulators.

Let’s not over-complicate this: We need to do 3 things to rein in the worst aspects of derivatives, and dramatically reduce the systemic risk they present, while retaining their ability to be a valid financial instrument for hedging risk:

1. Repeal the Commodity Futures Act of 2000

2. Treat Derivatives like all other financial instruments: All of the above elements need to be derivative requirements;

3. Give the Commodity Futures Trading Commission full oversight and the teeth to enforce the rules.

Wall Street and the banks will fight this tooth and nail, as they are reaping billions in derivative trading profits. Never mind that whole 2008-09 meltdown thingie — that’s ancient history.

This is simple, folks: Derivatives should not receive special treatment — they need to be regulated the way most other financial products in the world are.

http://www.businessweek.com/news/2010-03-15/goldman-sachs-demands-derivatives-collateral-it-won-t-dish-out.html

March 15 (Bloomberg) -- Goldman Sachs Group Inc. and JPMorgan Chase & Co., two of the biggest traders of over-the- counter derivatives, are exploiting their growing clout in that market to secure cheap funding in addition to billions in revenue from the business.

Over the last three years, Goldman Sachs has extracted more collateral from counterparties in the $605 trillion over-the- counter derivatives markets, according to filings with the SEC.

The banks get to use the cash collateral, said Robert Claassen, a Palo Alto, California-based partner in the corporate and capital markets practice at law firm Paul, Hastings, Janofsky & Walker LLP.

“They do have to pay interest on it, usually at the Fed funds rate, but that’s a low rate,” Claassen said.

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ISDA®
INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.
NEWS RELEASE
For Immediate Release, Monday, March 15, 2010


ISDA Comments on Sovereign CDS

NEW YORK, Monday, March 15, 2010 – The International Swaps and Derivatives Association, Inc. (ISDA) today issued the following statement regarding credit default swaps (CDS) on sovereign reference entities.

There has been a significant amount of attention in the last several days regarding sovereign CDS and the extent to which naked sovereign CDS are dictating the prices of the underlying bond markets. This discussion has led some to propose that naked sovereign CDS be banned or suspended. ISDA wishes to address certain issues in this debate: market and instrument transparency, outstanding sovereign CDS volumes and the possible impact of sovereign CDS on the underlying Greek government bond market.

Improved Market Transparency
Critics of the CDS market assert that the market is complex and opaque. At the same time, the critics argue that, despite its complexity and opaqueness, the CDS market is liquid enough to influence markets of enormous size. ISDA believes this line of reasoning is flawed and inconsistent.

ISDA believes that the most commonly traded CDS, including sovereign CDS, are simple and relatively liquid. At the same time, the market for sovereign CDS is much smaller than the underlying market for government bonds.

It is also ISDA’s view that the CDS market is far from opaque. Market participants and the general public have ready access to data to evaluate market activity. The amount of outstanding CDS and weekly transaction activity for the 1,000 largest names (including sovereign CDS) are publicly available through the website of DTCC`s Trade Information Warehouse (www.dtcc.com/products/derivserv/data/index.php). In addition, policymakers have access to transaction level data to evaluate market activity.

Outstanding Sovereign CDS Volumes
The table at the bottom of this release shows the most recent net outstanding CDS positions for the largest sovereign names, with a net position of $9 billion for the Hellenic Republic.

Examination of DTCC’s reports since the beginning of 2010 shows the net outstanding CDS position on the Hellenic Republic has changed little over the course of this year. The net position for Greece was $8.7 billion in the week of January 1, 2010 and has ranged between $8.5 billion and $9.2 billion since then. Furthermore, the DTCC data indicates the net position for Greece was $7.4 billion a year ago. None of the data suggests there has been a surge of open interest in either 2009 or 2010.

Impact of Naked Sovereign CDS on Greek Government Bond Market
The activity and outstanding volumes in the Greek CDS market need to be contrasted with the outstanding volumes in the Greek government bond market, which exceeds $400 billion. None of the data can possibly lead to a conclusion that a market of $9 billion can dictate prices in the $400 billion government market.

Indeed, if prices in the CDS market widened significantly relative to the Greek government market, arbitrageurs and holders of Greek government bonds would simply sell the bonds and write protection in the form of the sovereign CDS. The fact that government bond and CDS spreads have remained essentially in line while outstanding positions have remained constant underlies our assertion that the CDS market has had little or no impact on the government market.

It is important to understand that Greek CDS are useful for controlling risk for investors and lenders. Greek CDS provide effective hedges not only for holders of Greek government bonds but also for international banks that extend credit to Greek corporations and banks, for investors in Greek stocks and for entities that have significant real estate or corporate holdings in Greece. For many of these participants, the sovereign CDS market is the most effective means of hedging credit risk in Greece. Recent anecdotal evidence indicates that banks with significant credit exposure to entities in Greece have been active purchasers of Greek sovereign CDS protection. Much of this activity could be misinterpreted as “naked CDS.” ISDA further believes that this activity cannot have any significant impact on Greek government prices because of its insignificant size in relation to the underlying government bond market.

Recently, a simplistic analogy has surfaced and been repeated that compares CDS to fire insurance. People who use this analogy point to insurance law prohibiting individuals from buying insurance on a neighbor`s house so that they will not burn it down to collect the insurance proceeds. Under this analogy, writing naked CDS is equivalent to buying such insurance and committing arson and should therefore be banned.

The analogy leaves some important points unsaid: How, for example, can buyers of naked CDS actually burn down the house? It is important to remember that for every buyer of CDS there is a corresponding seller who benefits when the reference entity’s credit quality improves. It is unclear how such activity alone can lead to a default by a sovereign government on bonds it has issued. Such claims ignore the commonsense facts available and fail to show either cause or effect. These claims also ignore short selling activity in Greek government bonds, which certainly has a greater effect on Greek bond prices as it involves selling the actual instruments in the market.

ISDA Remains Committed to Engaging with Policymakers
ISDA supports the efforts of global policymakers in examining the CDS and other derivatives markets to ensure they are safe and efficient. ISDA believes policymakers should have the supervisory tools and authority to take action should any abuses be found in the operations of any financial market.

About ISDA
ISDA, which represents participants in the privately negotiated derivatives industry, is among the world’s largest global financial trade associations as measured by number of member firms. ISDA was chartered in 1985, and today has over 810 member institutions from 57 countries on six continents. These members include most of the world’s major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities. Information about ISDA and its activities is available on the Association's web site: www.isda.org.

ISDA® is a registered trademark of the International Swaps & Derivatives Association, Inc.


Sovereign Reference Entity Net Notional
Republic of Italy: $26 billion
Kingdom of Spain: $16 billion
Federal Republic of Germany: $13 billion
Federative Republic of Brazil: $12 billion
Portuguese Republic: $ 9 billion
Republic of Austria $ 9 billion
French Republic $ 9 billion
Hellenic Republic $ 9 billion

(Note: data is of February 27th. Net notional represents the maximum possible net funds transfer (excluding any recoveries) between net sellers of protection and net buyers of protection that could be required upon the occurrence of a reference entity credit event. The industry uses net notional rather than gross notional as most contracts remain outstanding even as risk is offset. For example, if a client writes or buys protection through a CDS, the client will typically use a dealer and the dealer making the price to the client will very often trade a CDS with another dealer to offset its position. This dealer, in turn, may lay off its position with another dealer. Thus the gross position increase but the actual risk is the amount of the original transaction.


You are receiving this email as notification of an ISDA Press Release distribution. If you no longer wish to receive these emails please visit the following: http://eseries.isda.org/unsubscribe-press/remove.asp

Clearly I disagree. Dealer community through Markit has a clear information advantage. The following may be a game changer.

BOCA RATON, Fla. -(Dow Jones)- An official at the Federal Housing Finance Agency said Thursday that Fannie Mae (FNM: 1.03, -0.04, -3.74%) and Freddie Mac (FRE: 1.24, -0.05, -3.88%) will clear a large portion of the swaps on their books "in months" even if Congress fails to pass a bill to mandate central clearing.

"If there is no legislation, Fannie Mae and Freddie Mac are still going to go to central clearing," said Martha Tirinnanzi, the head of a clearing workgroup in the FHFA's office of market risk.

"We see that as the outcome of 2008. It is the responsible thing to do and the right thing to do. It is the right thing to do for our country and it is the right thing to do for Fannie Mae and Freddie Mac," she added during a conference held by the Futures Industry Association.

The FHFA is the regulator of Fannie and Freddie, the two large government-controlled suppliers of funding for home mortgages.

Both government-sponsored enterprises are major players in the interest rate swap market, which they use as a hedging tool against interest rate fluctuations.

Tirinnanzi said that both Freddie and Fannie each hold a notional value of between $700 billion to $800 billion in interest rate swap contacts that are "plain vanilla" and likely eligible for clearing.

Tirinnanzi said in the past few months, Fannie and Freddie have been "kicking the tires" in testing out various interest rate swap clearing platforms to see which would be the right fit.

They have tested clearing using a "shadow portfolio" of swaps with the new Nasdaq-owned International Derivatives Clearing Corp., as well as London-based LCH.Clearnet and a clearing platform still in a development phase owned by CME Group Inc. (CME: undefined, undefined, undefined%). A final decision on which clearinghouse will be primarily used for Fannie and Freddie hasn't yet been decided.

A move toward clearing by two of the interest rate swap market's biggest players could potentially help shift the debate on the regulatory overhaul for over-the-counter derivatives legislation.

The head of the U.S. Commodity Futures Trading Commission, who spoke earlier Thursday at the conference, is calling for major new regulations, opposed largely by Wall Street, that would force standard over-the-counter products onto trading platforms and through clearinghouses, which guarantee trades.

Tirinnanzi said the goal is ultimately to "remove counterparty credit risk" off the books of the GSEs and the FHFA is in agreement on the kinds of regulations that CFTC Chairman Gary Gensler is advocating.

"I think that when Fannie Mae and Freddie Mac begin executing and moving those derivative trades into central clearing, that it will be a signal to the sell-side that this market has changed," she said. "We've got the largest swap participants in the United States that are saying this is the beginning of the end of the OTC world."

the trades sre still done w/ dealers. just now after execution the trades will face the exchange. same w/ cds now. riversider go back to sleep.

did the specialist on the floor of the NYSE ever take advantage of investors?

all of the time

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clearing first, exchange trading second. there's no reason not to, unless the goal is to rip off clients.

if exchnage trading is so great, then why is the floor of NYSE extinct? why are the floors of the cme / cbot going extinct? why is the nasdaq an efficient market place? NASDAQ = OTC . pls just go back to sleep. you have no concept of how capital markets and the players in them operate.

mbs pools are moving from over the counter to electronic trading. we don't need a physical exchange to make it work.

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JPMorgan, Bank of America Corp., Goldman Sachs, Morgan
Stanley and Citigroup Inc. executed 96 percent of the $293
trillion in over-the-counter derivatives trades made by the top
25 U.S. bank-holding companies and their customers as of Sept.
30, according to the Office of the Comptroller of the Currency.

“If we can have more members or participants it would be a
good thing” for the stability of the clearinghouses and the
market, said Patrice Blanc, chief executive officer of Newedge
USA LLC, the world’s largest futures broker, which is aware of
the regulatory lobbying though not a member of the group. “The
banks don’t want to open the model; they’re making too much
money.”

Only firms with a net worth of at least $5 billion are
allowed to be members of the largest credit-default swap
clearinghouse, Intercontinental Exchange Inc.’s ICE Trust. At
CME Group Inc.’s venture, that requirement is $500 million,
recently raised from $300 million. Both demand expertise in the
market, including swaps-trading desks.

executives and spokespeople from the firms said.
“We’re working with regulators and exchanges to impress
upon them the importance of diverse models” of how brokers and
banks can gain access to clearinghouses, said Bernard Dan, chief
executive officer of MF Global, which isn’t a member of the
group. The broker is building its capabilities and hiring
traders in the credit-swaps market so that “maybe in six to
eight months we’ll be seen as a major execution agency player,”
he said.

And this from the man who worked towards passing of the commodity futures modernization act(what a poorly chosen name)

http://www.risk.net/risk-magazine/news/1595684/cftc-chairman-attacks-credit-default-swaps

“I really do think CDSs directly contributed to the financial crisis of the past year-and-a-half,” commented Gensler, during his keynote address.

Like other derivatives, CDSs serve a price discovery function. However, they also have characteristics that separate them from other products, Gensler said. While the value of interest rate or commodity derivatives generally adjust continually based on a reference rate or asset, CDSs operate more like binary options. “CDSs can quickly turn from a consistent revenue generator into a ruinous cost for the seller of protection. This jump-to-default payout structure makes it more difficult to manage the risk,” he said.

Before the crisis, he said, many banks used CDSs to lower their regulatory capital to dangerous levels: by purchasing CDS protection, banks had been able to essentially “rent out” another firm's credit rating, such as AIG's, and CDSs also contributed to weak underwriting standards.

“CDSs have characteristics similar to bond insurance issued by monoline insurance providers. Further, credit default swaps based upon a single company relate directly to that company’s capital formation and to the price of its equities, bonds and other securities,” he said.

Gensler affirmed his belief in the empty creditor hypothesis, in which holders of CDSs and bonds seek to push companies towards bankruptcy for their own economic benefit. He evoked parallels with the English insurance industry of the 1700s, when individuals were able to buy insurance for ships they didn't own. “It should come as no surprise that seaworthy ships began sinking,” he said.

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Given the circumstances, I think Gensler's statements make sense.

http://www.ft.com/cms/s/0/074757e8-333f-11df-bc32-00144feabdc0.html

Jean-Claude Trichet, president of the European Central Bank, on Friday threw his support behind tougher regulation and oversight of the huge credit default swap market.

It was important that “certain financial instruments, which were introduced in consideration of their positive effects for the hedging of risks, should not be misused in a speculative manner”, he told a Brussels-based conference on bank crisis management.

“I share the consensus at global level that regulators should be equipped with appropriate tools to be able to investigate and act in an effective and co-ordinated manner. We need more transparency in CDS markets and so do investors,” he said.

http://www.ft.com/cms/s/0/074757e8-333f-11df-bc32-00144feabdc0.html

Jean-Claude Trichet, president of the European Central Bank, on Friday threw his support behind tougher regulation and oversight of the huge credit default swap market.

It was important that “certain financial instruments, which were introduced in consideration of their positive effects for the hedging of risks, should not be misused in a speculative manner”, he told a Brussels-based conference on bank crisis management.

“I share the consensus at global level that regulators should be equipped with appropriate tools to be able to investigate and act in an effective and co-ordinated manner. We need more transparency in CDS markets and so do investors,” he said.

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I would accept regulation if it included central clearing , exchange trading, positions limits and reasonable margin requirements.

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Churlish response...
And buy-side is revolting from going through the dealers and starting to buy direct from Treasury in greater numbers. And stock trades done on exchange/exchange hours have the best executions.

Over the counter means, anonymity, lack of records and transparency...

in other words those who want over-the-counter prefer to deal in the shadows.

Exchange trading brings, speed, fairness,transparency, liquidity and lower cost.

It's the difference between transparency and opacity

then why is the floor of the NYSE prctically empty today ? why are the floors of the CME / CBOT becoming empty?

Electronic trading...
Exchanges do not have to be physical

what is nasdaq?

Face it we had the melt down because of CDS. Nobody knew anyone's exposure and everyone became afraid their counter-party couldn't cover. Nobody knew what things were worth because there was no transparency in the swaps market. And firms like Goldman may have hastened the demise of some of their competitors by forcing collateral callas at the worst possible time(Goldman was not a clearing house, their motives were not just protecting their position as being on the other side of a trade).

Further more a cds does not allocate capital. When I buy a bond, I'm allocating capital. A CDS or a total return swap on an asset, is at best someone's hedge, and at worst a pure side bet. Saying someone going long "gains exposure" is just a fancy word for bet and has nothing to do with capital formation.

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