Credit Default Swaps (CDSs) and Systemic Risks

Transcription

1 Journal of Modern Accounting and Auditing, ISSN June 2012, Vol. 8, No. 6, D DAVID PUBLISHING Credit Default Swaps (CDSs) and Systemic Risks Eliana Angelini G. D Annunzio University of Pescara, Italy The use of credit default swaps (CDSs) has become increasingly popular over time. Between 2002 and 2007, gross notional amounts outstanding grew from below $2 trillion to nearly $60 trillion. The recent crisis has revealed several shortcomings in CDS market practices and structure. In addition, management of counterparty risk has proved insufficient, as has in some instances the settlement of contracts following a credit event. However, past problems should not distract from the potential benefits of these instruments. In particular, CDSs help complete markets, as they provide an effective means to hedge and trade credit risk. CDSs allow financial institutions to better manage their exposures, and investors benefit from an enhanced investment universe. The purpose of this paper is to present a complete and practical exposition of the CDS market and to explore how the development of the CDS market has played an important role in the credit risk markets. Currently, the CDS market is transforming into a more stable system. Various measures are being put in place to help enhance market transparency and mitigate operational and systemic risk. In particular, central counterparties have started to operate, which will eventually lead to an improved management of individual as well as system-wide risks. Keywords: credit derivatives, credit default swap (CDS), credit risk, counterpart risk, systemic risk Introduction The credit default swap (CDS) is a simple derivative contract that has revolutionized the trading of credit risk. In its simplest form, a CDS is used to transfer the credit risk of a reference entity (corporate or sovereign) from one party to another. In a standard CDS contract, one party purchases credit protection from another party, to cover the loss of the face value of an asset following a credit event. A credit event is a legally defined event that typically includes bankruptcy, failure-to-pay, and restructuring. This protection lasts until some specified maturity date. To pay for this protection, the protection buyer makes a regular stream of payments, known as the premium leg, to the protection seller. CDS allows credit risks to be separated from the underlying credit relationship and to be traded separately. A broader distribution of credit risks improves the financial system s overall ability to absorb shocks. Furthermore, CDS even allows for greater risk distribution in those sectors which cannot function as a direct creditor in credit operations. For many years, these instruments have been touted as an efficient means of distributing risk and promoting financial stability. The market for CDSs has experienced explosive growth in the past. CDSs have existed since the early 1990s and the market increased tremendously starting in However, in recent events, developments in the CDS markets helped to fuel the current financial crisis. The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly because Lehman Brothers and American International Group (AIG) were counterparties in a very large number of CDS transactions. By the end of 2007, the outstanding amount was $62.2 trillion, falling to Eliana Angelini, Ph.D., professor, Department of Economics, G. D Annunzio University of Pescara.

2 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS 881 $38.6 trillion by the end of The recent crisis has revealed several shortcomings in CDS market practices and structure. In addition, management of counterparty risk has proved insufficient, as has in some instances the settlement of contracts following a credit event. The purpose of this paper is to present a complete and practical exposition of the CDS market and to explore how the development of the CDS market has played an important role in the credit markets stability. How Does CDS Work Within an economy, a broad variety of entities have a natural need to assume, reduce, or manage credit exposures. These include banks, insurance companies, hedge funds, fund managers, corporate and government agencies. Each type of player will have different economic or regulatory motives for wishing to take positive or negative credit positions at particular times. In simple terms, credit derivatives are instruments that transfer part or all of the credit risk of an obligation, without transferring the ownership of the underlying asset. Contracts can refer to single credits or diverse pools of credits (such as in synthetic Collateralized Debt Obligations, CDOs, which transfer risk on entire credit portfolios). Credit default swaps are the most important and widely used instruments in the credit derivatives market. In simple terms, a credit default swap is a bilateral agreement between two counterparties to transfer the credit risk of one or more reference (See Figure 1). The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event (Tavakoli, 1998; Das, 1998, 2006). Figure 1. The credit default swap. A credit event is usually a default or, possibly, a credit downgrade of the entity; or the restructuring of liabilities to the detriment of the creditors. These credit events are documented by using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific requirements. CDSs are traded over-the-counter (OTC market), allowing for an agreement which better suits the more specific needs of both counterparties. However, in practice the vast majority of transactions in the market are quite standardized. The reference entity may be a name, a bond, a loan, a trade receivable or some other types of liability. The CDS may refer to a specified loan or a bond obligation of a reference entity, usually a corporation or government. A CDS resembles an insurance contract, in that it protects the protection buyer against pre-defined

3 882 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS credit events, in particular the risk of default, affecting the reference entity (or entities), during the term of the contract, in return for a periodic fee (or spread ) paid to the protection seller 1. There are two types of conditional payments. One type of payment is a predetermined fixed cash amount. The other type of payment, determined at the time of the credit event, is equal to the difference between the face value and the recovered amount of the reference entity, this payment is made either at the time of the credit event or at the maturity of the contract. There are also several variations of premium payments. The premium may be paid at inception or may be paid over time as a fixed or variable amount. A default swap with a payoff of a fixed amount is known as a binary (cash or nothing) default swap. A default swap with its premium paid at inception is also called a default put. The value of a default swap depends not only on the credit quality of the underlying reference entity but also on the credit quality of the writer, also refers to as the counterparty. If the counterparty defaults, the buyer of a default swap will not receive any payment if a credit event occurs. We also note that the premium payments end, if the counterparty defaults. Hence, the value of a default swap depends on the probability of counterparty default, probability of entity default, and the correlation between them. If the CDS is based on a credit relationship with only one borrower (single-name CDS), the risk shedder transfers the reference asset (e.g., bonds or loans) to the risk taker. If this is done by the physical delivery of securities (physical settlement is the market standard), the risk shedder usually has the choice among securities of the same kind (cheapest to deliver option). Cash settlement is another option. This involves an agreement to pay the difference between the nominal value of the reference asset and its market value following a credit event. This is particularly favored, when a CDS backs a loan portfolio from which individual loans are more difficult to separate. The recovery rate of a reference entity also plays an important role in default swap valuation. It must be handled carefully. In the case of a bond, its recovery rate can refer to a recovery rate of its principal only or to a recovery rate of both its principal and accrued interests. A recovery rate can also be deterministic or random. However, under the assumption that a recovery rate is independent of other variables, a random recovery rate can be replaced by its expected value and hence only deterministic recovery rates need to be considered. A holder of a bond may buy protection to hedge its risk of default. In this way, a CDS is similar to credit insurance, although CDS is not similar to or subject to regulations governing casualty or life insurance. Also, investors can buy and sell protection without owning any debt of the reference entity. These naked CDSs allow traders to speculate on debt issues and the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity. Naked CDS constitutes most of the market in CDS. In addition, credit default swaps can also be used in capital structure arbitrage. Size and Relevance of the CDS Market Credit derivative markets have grown rapidly since the mid-1990s. The aggregate gross notional amount of outstanding credit derivative contracts 2 rose from about $4 trillion at year-end 2003 to just over $60 trillion 1 The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or Risky Corp defaults. Payments are usually made on a quarterly basis, in arrears. 2 Gross notional value is the sum of CDS contracts bought (or equivalently sold) across all counterparties, each trade is counted once.

4 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS 883 at year-end The outstanding notional amount subsequently fell back to about $31 trillion by June 30, 2009, and will likely continue to fall (See Figure 2). Figure 2. Global credit derivatives outstanding (trillions of dollar). Sources: BIS (2009), ISDA (2009a, 2009b). CDSs are the most important and widely used instruments in the credit derivatives market. Although most of the recent growth in credit derivative volumes has occurred among the multi-name products, single-name contracts still account for almost 60% of gross notional amounts outstanding. Of these single-name contracts, investment-grade corporate obligations (i.e., those rated BBB- and better) comprise most of the underlying credit risk transferred (See Figure 3). Figure 3. CDS gross notional amount outstanding. Sources: BIS (2009); ISDA (2009a, 2009b). The market for credit derivatives is a global market in which particularly banks, credit insurers, reinsurers, hedge funds, major non-financial enterprises. The liabilities of non-financial enterprises comprise the largest share of the reference obligations. At first, banks were the dominant players in the market, as CDS was primarily used to hedge risk in connection with its lending activities 4. The growing number of bankruptcies and particularly the rising 3 The actual size of the credit derivatives market is difficult to estimate since most products are traded over-the-counter and data providers use different sampling and collection methods. There are three main data sources: (1) the Bank for International Settlement [BIS], which conducts a semi-annual as well as a more comprehensive triennial survey among national central banks; (2) the International Swaps and Derivatives Association [ISDA] with its semi-annual market survey; and (3) the Depository Trust and Clearing Corporation [DTCC], which collects data in gross and net terms from its warehouse. 4 By March 1998, the global market for CDS was estimated about $300 billion, with JP Morgan alone accounting for about $50 billion of this.

5 884 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS frequency of insolvencies of large enterprises in the period from 2001 to 2003 heightened market participants sensitivity to credit risks at an early stage in the markets development. Moreover, low transaction costs, which fell further as the bid/ask spreads narrowed, as well as the standardization by the ISDA of contract terms and conditions, enhanced the attractiveness of the CDS market. It is precisely in comparison to conventional methods of credit risk transfer that CDS proves to be a cost-effective alternative. For example, in the case of CDS, only the credit risk is transferred; the underlying relationship between the borrower and lender remains intact. Changes to credit risk management in the banking sector are an additional factor contributing to greater use of CDS. As part of their credit risk management, banks are viewing CDS more and more often as tradable products, which can be transferred to third parties before the maturity date. Moreover, CDS has also been combined to create new financial instruments, to better satisfy the needs of the risk shedder and risk taker. Banks also saw an opportunity to free up regulatory capital. The high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge funds saw trading opportunities in CDSs. By 2002, investors as speculators, rather than banks as hedgers, dominated the market. Six years later, by year-end 2002, the outstanding amount was over $2 trillion. Although speculators fueled the exponential growth, other factors also played a part. An extended market could not emerge until 1999, when ISDA standardized the documentation for CDSs. Also, the 1997 Asian Financial Crisis spurred a market for CDS in emerging market sovereign debt. In addition, in 2004, index trading began on a large scale and grew rapidly. By the end of 2007, the CDS market had a notional value of $62.2 trillion. But notional amount fell during 2008 as a result of dealer portfolio compression operations that eliminate redundant offsetting contracts 5. By the end of 2008, notional amount outstanding had fallen 38% to $38.6 trillion. In 2008, there was no centralized exchange or clearing house for CDS transactions; they were all done over the counter (OTC). This led to recent calls for the market to open up in terms of transparency and regulation. The market for CDSs attracted considerable concern from regulators after a number of large scale incidents in U.S. and European regulators are developing separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, administered by ISDA. Two of the key changes are: (1) Introduction of central clearing houses, one for the U.S. and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face; (2) International standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the payout should be is unclear. In the U.S., central clearing operations began in March 2009, operated by Inter-Continental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group (Chicago Mercantile Exchange Group). In Europe, CDS Index clearing was launched by ICE s European subsidiary ICE Clear Europe in July Portfolio compression is a technique which reduces the overall notional size and number of outstanding contracts in credit derivatives portfolios without changing the risk profiles of the underlying portfolios. This is achieved by terminating existing trades and replacing them with a smaller number of new replacement trades that carry the same risk profile and cash flows as the initial portfolio but requires a smaller amount of regulatory capital to be held against these positions.

6 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS 885 Various Forms of CDSs CDSs can come in various forms depending on the underlying reference entity and any other varying contractual definition (Amato & Gyntelberg, 2005; Kiff, Elliott, Kazarian, Scarlota, & Spackman, 2009). There are three main types of CDS. First, the single-name CDS, the traditional and most common form of CDSs, offers protection for an individual corporate or sovereign reference entity. Second, CDS indices are the key product among multi-names. Index CDSs are contracts which consist of a pool of single-name CDSs, whereby each entity has an equal share of the notional amount within the index. They use an index of debtors as reference entity, incorporating up to 125 corporate entities. If a firm in the index defaults, the protection buyer is compensated for the loss and the CDS notional amount is reduced by the defaulting firm s pro rata share. The degree of standardization is the highest for these contracts. Liquidity for benchmark indices is enhanced by including only the most liquid single-name CDSs. Market participants have come to view the CDS indices as a key source of price information. CDS indices do not cease to exist after credit events, instead continuing to trade with reduced notional amounts. In addition, a market has also developed for CDS index tranches, whereby CDS contracts relate to specific tranches (also known as synthetic CDOs [collateralized debt obligations] ) within an established CDS index. Each tranche covers a certain segment of the losses distributed for the underlying CDS index as a result of credit events. Third, basket CDSs are similar to indices, as they relate to portfolios of reference entities, which can comprise anything from three to 100 names. However, basket CDSs may be more tailored than index contracts and are more opaque in terms of their volumes and pricing. Single-name and multi-name CDSs constitute the dominant form of CDS (See Figure 4). Figure 4. Gross notional amounts. Source: DTCC (2009). While single-name contracts account for the majority of all trades, multi-name contracts have become almost as popular during recent years. The rapid growth of this market segment is due to index trades being used increasingly for trading purposes as well as for proxy hedges. Besides plain CDSs, such as single-name or

7 886 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS index CDSs, more sophisticated products exist. Credit derivatives include also funded and unfunded synthetic CDOs offering tranched claims to a portfolio of CDSs, or in the form of tranched index CDSs on a CDS index. Following the crisis, demand for the more complex structures, such as CDOs on CDOs often called CDOs-squared appear to have ceased. By contrast, the simpler tranched index CDSs continue to be widely used. Counterparty Risk and Systemic Stability Operational risks have been considered as a possible source of disruption in CDS markets, as the rapid market growth in volumes over the last 10 years has outstripped trade processing and risk management infrastructures 6. However, banks and dealers and other authorities have made important infrastructure improvements. In addition, dealers have consistently been meeting or exceeding benchmarks set by authorities for confirmation lag reductions. Market participants now benefit from a range of mechanisms that have helped improve the management of operational risk and make transactions more secure. Owing to a number of private, regulator-backed initiatives, the CDS market place has become one of the most highly automated OTC markets. Since 2005, the industry has been seeking to solve the problem of operational risk arising from confirmation backlogs. Nevertheless, trade processing remains a source of operational risk (Kiff et al., 2009) 7. Although important strides have been made in reducing operational risks, counterparty risk remains a significant problem in these and other OTC derivatives markets (Bliss & Kaufman, 2006; Duffie & Zhu, 2009). In contrast to interest rate swaps but similar to options, the risks assumed in a CDSs by the protection buyer and protection seller are not symmetrical. The protection buyer effectively takes on a short position in the credit risk of the reference entity, which thereby relieves the buyer of exposure to default. By giving up reference entity credit risk, the buyer effectively gives up the opportunity to profit from exposure to the reference entity. In return, the buyer takes on: (1) Counterparty default exposure to simultaneous default by the reference entity and the protection seller ( double default ); (2) Counterparty replacement risk of default by the protection seller only. In addition, the protection buyer takes on basis risk to the extent that the reference entity specified in the CDS does not precisely match the hedged asset. A bank hedging a loan, for example, might buy protection on a bond issued by the borrower instead of negotiating a more customized, and potentially less liquid, CDS linked directly to the loan. Another example would be a bank using a CDS with a five-year maturity to hedge a loan with four years to maturity. Again, the reason for doing so is liquidity, although with the expansion of CDS markets, the concentration of liquidity in specific maturities will lessen. The protection seller, in contrast, takes on a long position in the credit risk of the reference entity, which is essentially the same as the default risk taken on when lending directly to the reference entity. The main difference between the two is the need to fund a loan but not a sale of protection. The protection seller also takes on counterparty risk because the seller will 6 Settlement risks may also arise because the gross notional value of some CDS contracts far exceeds the outstanding amount of underlying deliverable obligations. Almost all CDS contracts specify physical delivery upon a credit event, whereby the protection buyer delivers a qualifying physical obligation in return for receiving the par amount from the protection seller. This can obviously lead to problems when CDS contracts outstanding exceed the stock of deliverable obligations. 7 Although about 90% of credit derivatives transactions are now being confirmed electronically, compared to about 75% in 2004, the other 10%, comprised mostly of customized contracts, is associated with significant volumes of unconfirmed and failed trades. These are often processed with long delays, and in some cases are incomplete and inconsistent, making accurate counterparty risk management difficult. In addition, audit trail data are not readily available and must be reconstructed manually.

8 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS 887 lose expected premium income if the buyer defaults (Mengle, 2007) 8. Counterparty risk is the focal point of attention on the CDS market, as it is on all OTC markets. The very high level of concentration that is characteristic of the CDS market, combined with a higher risk of correlation between the protection seller and the underlying entity, transforms the shortcomings of counterparty risk management into a potential systemic risk. A number of structural features in the CDS market have helped to transform counterparty risk into systemic risk. First, the majority of the CDS market remains concentrated on a small group of dealers. Second, the case of Lehman Brothers has shown that the interconnected nature of this dealer-based market can result in large trade replacement costs for market participants in the event of dealer failures. According to DTCC data, the five largest CDS dealers were counterparties to almost half of the total outstanding notional amounts as in April 2009 and the 10 largest CDS dealers were counterparties to 72% of the trades (see Figure 5) 9. Figure 5. Total notional amounts of outstanding CDSs sold by dealers, broken down by rating. Source: DTCC (2009). Market concentration has increased, following the default of financial entities active in CDS trading, such as Lehman Brothers, along with the near-bankruptcy of AIG, the disappearance of key players like Bear Stearns and the exit of numerous hedge funds. In terms of systemic risk, two issues arise: the increase in counterparty risk and the extent to which credit risk has actually been transferred. The credit risk still haunts the financial system and therefore the banking system. Although risk remains within the financial sector, the protection sold by market participants relates to that very sector. On May 1, 2009, nearly 40% of gross outstanding in single-name CDS concerned reference entities in the financial sector (See Figure 6). 8 One exception to the above risk allocation is the funded CDS (also called a credit linked note), in which the protection seller lends the notional amount to the protection buyer in order to secure performance in the event of default. In a funded CDS, the protection buyer is relieved of counterparty exposure to the protection seller, but the seller now has exposure to the buyer along with exposure to the reference entity. In order to reduce the seller s exposure to the buyer, the parties sometimes establish a bankruptcy-remote entity, known as a special-purpose vehicle that stands between the two parties and is independent of default by the protection buyer. 9 These proportions are also valid for the gross notional amounts bought and sold.

9 888 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS Figure 6. Gross notional amount sector analysis of the top 100 reference entities. Source: DTCC (2009). There is a significant risk of double default, that is, the default of an entity that is both an active counterparty on the market and a CDS underlies. In terms of net notional amounts (i.e., the maximum amount at risk), seven dealers are among the top 10 reference entities (See Table 1). Table 1 Top 10 Reference Entities by Net Protection Amounts Net USD billion General Electric Capital Corporation Deutsche Bank Aktiengesellschaft 7.16 Bank of America Corporation 6.80 Morgan Stanley 6.32 The Goldman Sachs Group, inc Merrill Lynch & Co., inc Berkshire Hathaway inc Barclays Bank PLC 4.36 UBS AG 4.31 The Royal Bank of Scotland Public Limited Company 4.27 Note. Source: DTCC (2009). Instead of redistributing credit risks, CDSs have actually contributed to intensifying systemic risk by concentrating exposure on a handful of highly interconnected players that are simultaneously buyers, sellers, and underlies. When the underlying reference entity for a CDS is a financial institution, the counterparty risk effect can be substantial, as the intermediaries in the CDS market are other financial institutions. In particular, the values of large global financial firms fluctuate together, owing to their interconnectedness in the global markets. The fact that such institutions are tied to each other through chains of OTC derivative contracts means that the failure of one institution can substantially raise CDS spreads on other institutions, making it difficult for

10 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS 889 investors to separate the credit risk of the debtor from CDS counterparty risk. The need to hedge counterparty exposures has therefore not created for risk management purposes 10. These observations underscore the need to upgrade the operational management of counterparty risk, which will be achieved partly by setting up clearinghouses for the credit derivatives market, and to increase market transparency. The aim is to improve the assessment of counterparty risk, in the interest not only of regulators but also of market participants. Until recently, government authorities have focused their attention on the markets for exchange-traded derivatives, while maintaining a very hands-off approach to OTC derivative markets. One of the main reasons for the difference in treatment has been that the OTC markets are considered wholesale markets for professional participants who have the competence and the ability to assess the inherent risks, while the markets for exchange-traded contracts are seen as also involving retail investors. However, the recent financial turmoil has shown that OTC derivative markets can negatively affect other functioning financial markets and can be a serious risk to the health of the banking system. These observations have prompted the authorities to re-examine their hands-off stance, and there have been increasing calls for the regulation and oversight of OTC derivatives markets, and especially CDS markets. Central counterparties (CCPs) can go a long way towards alleviating many of these counterparty risks 11. The recent CCP launches in Europe and the United States are promising developments. A CCP reduces systemic risk by applying multilateral netting. However, a single global CCP would accomplish the largest reduction in systemic counterparty risk, benefit from the largest network and scale economies and a larger pool of counterparty and resource base, and limit opportunities for regulatory arbitrage and competitive distortions. Some CDS market systemic risk concerns could be alleviated if policymakers and market participants had access to more detailed transaction and position information. Better information would also enable authorities to detect market abuse. More effective CDS market surveillance will require clearer regulatory and supervisory. Conclusions CDS is the most important and widely used instrument in the credit derivative market. It is a contract that provides protection against credit loss on an underlying reference entity as a result of a specific credit event. A default is referred as a credit event and includes such events as failure to pay, restructuring, and bankruptcy. 10 The increasing correlation between counterparties and reference entities has recently taken on a new dimension in those countries whose banking sector has been supported by public authorities. The sovereign CDS market for developed countries has surged following the launch of national bank rescue packages. Third, market participants which were not perceived to be key or major players within the CDS market prior to the outbreak of the crisis in terms of gross notional amounts have been shown to be too large to fail owing to their links with other key market participants. 11 Clearinghouses step into the middle of derivatives trades, becoming the buyer to every seller, and the seller to every buyer. By ending the bilateral relationships between the two counterparties to derivative contracts, central clearinghouses reduce the risk that the failure of any one party could trigger domino-effect losses on other counterparties. Clearinghouses protect themselves against their own failure, meanwhile, through several measures. They require both parties to the trade (currently the dealers, but ultimately also end-users who may eventually participate) to post initial cash margin and continuously update it through variation margin that is tied to the market value of the derivative. As backup, clearinghouses require members to contribute capital to a reserve fund. As further backup, clearinghouses assess their members for any losses the first two mechanisms might fail to cover.

11 890 CREDIT DEFAULT SWAPS (CDSs) AND SYSTEMIC RISKS Conceptually, any innovation like this that unbundles risk allows these risks to be priced more efficiently. That it allows participants to hedge and allows capital to flow more freely to its highest-valued use has great benefits not only for financial markets but for our economy more generally. However, there are some concerns or potential for the risk of spillovers of any kind of adverse event in this market to the larger financial market. The reasons that there are some concerns are, one, that these contracts are largely bilateral. They are agreed to by two individual counterparties, not regulated through any exchanges. During the financial crises, the lack of transparency became a concern to regulators, as was the trillion dollar size of the market, which could pose a systemic risk to the economy. The recent crisis has revealed several shortcomings in CDS market practices and structure. Past problems should not distract from the potential benefits of these instruments. In particular, CDSs help complete markets, as they provide an effective means to hedge and trade credit risk. CDSs allow financial institutions to better manage their exposures, and investors benefit from an enhanced investment universe. Meanwhile, regulation should be designed with caution and be restricted to averting clear market failures. Regulators should avoid choking the market for bespoke credit derivatives, as many end-users are highly dependent on tailor-made solutions. From an analytical point of view, it has yet to be established under which conditions CDS trading as opposed to hedging does more harm than good, and whether central trading in addition to central clearing is required to achieve systemic stability. References Amato, J. D., & Gyntelberg, J. (2005, March). CDS index tranches and the pricing of credit risk correlations. BIS Quarterly Review, Bank for International Settlement [BIS]. (2009). OTC derivatives market activity in the first half of Retrieved from Bliss, R., & Kaufman, G. (2006). Derivatives and systemic risk: Netting, collateral, and closeout. Journal of Financial Stability, 2, Das, S. (1998). Credit derivatives: Trading & management of credit & default risk. New York: Wiley & Sons. Das, S. (2006). Traders, guns, and money. Harlow, U.K.: Pearson. Depositary Trust & Clearing Corporation [DTCC]. (2009). Annual report 2009: Making a difference. Retrieved from Duffie, D., & Zhu, H. (2009, March 9). Does a central counterparty reduce counterparty risk? (Stanford University Working Paper). International Swaps and Derivatives Association [ISDA]. (2009a). ISDA margin survey Retrieved from International Swaps and Derivatives Association [ISDA]. (2009b). ISDA launches hardwiring supplement and protocol, further enhancing consistency, transparency, and liquidity in CDS. ISDA Press Release. Kiff, J., Elliott, J., Kazarian, E., Scarlota, J., & Spackman, C. (2009). Credit derivatives: Systemic risks and policy options (IMF Working Paper). Mengle, D. (2007). Credit derivatives: An overview. Economic Review, 4, Tavakoli, J. M. (1998). Credit derivatives: A guide to instruments and applications. New York: Wiley & Sons.