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CreditDerivatives:SystemicRisksandPolicyOptionsJohnKiff,JenniferElliott,EliasKazarian,JodiScarlata,andCarolyneSpackmanWP/09/254©2009InternationalMonetaryFundWP/09/254IMFWorkingPaperCreditDerivatives:SystemicRisksandPolicyOptions?1PreparedbyJohnKiff,JenniferElliott,EliasKazarian,JodiScarlata,andCarolyneSpackmanAuthorizedfordistributionbyKarlHabermeierNovember2009AbstractThisWorkingPapershouldnotbereportedasrepresentingtheviewsoftheIMF.TheviewsexpressedinthisWorkingPaperarethoseoftheauthor(s)anddonotnecessarilyrepresentthoseoftheIMForIMFpolicy.WorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtofurtherdebate.Creditderivativemarketsarelargelyunregulated,butcallsareincreasinglybeingmadeforchangestothis“handsoff”stance,amidstconcernsthattheyhelpedtofuelthecurrentfinancialcrisis,orthattheycouldbeacauseofthenextone.Thepurposeofthispaperistoaddresstwobasicquestions:(i)docreditderivativemarketsincreasesystemicrisk;and(ii)shouldtheyberegulatedmoreclosely,andifso,howandtowhatextent?Thepaperbeginswithabasicdescriptionofcreditderivativemarketsandrecentevents,followedbyanassessmentoftheirrecentassociationwithsystemicrisk.Itthenreviewsandevaluatessomeoftheauthorities’proposedinitiatives,anddiscussessomealternativedirectionsthatcouldbetaken.JELClassificationNumbers:Keywords:FinancialDerivatives,FinancialStabilityAuthor’sE-MailAddress:jkiff@imf.org,jelliott@imf.org,ekazarian@imf.org,andjscarlata@imf.org.1ThispaperbenefitedgreatlyfromcommentsfromJochenAndritzky,CharlesBlitzer,RandallDodd,KarlHabermeier,MatthewJones,LauraKodres,andManmohanSingh.2ContentsPageI.Introduction............................................................................................................................3II.MarketStructureandRecentDevelopments.........................................................................3III.DoCreditDerivativeMarketsIncreaseSystemicrisk?.......................................................8A.OperationalRisksRemainbutareContinuingtoAbateAmidSignificantInfrastructureImprovements..........................................................................................8B.CounterpartyRiskExposuresRemainaSystemicConcern...................................15C.PoorDisclosureandTransparencyStandardsLeaveAuthoritiesintheDark........16D.LackofTransparencyandMarketSurveillanceCompromisesMarketIntegrity...16IV.ShouldCDSmarketsberegulatedmoreclosely?..............................................................17A.CentralizedClearinghousesWillReduceCounterpartyRisk.................................17B.NeedforRegulatoryCoordination..........................................................................22C.ImprovingDisclosureofCreditDerivativesTransactions......................................24D.ImprovingDisclosureinFinancialReportingofCreditDerivatives......................25E.ImprovingDisclosureofCreditDerivativesTransactionDatatoAuthorities........28F.ImprovingMarketIntegrityandSurveillance.........................................................29V.SummaryandConclusions..................................................................................................31Tables1.InitialCDSClearinghouseProposals...................................................................................212.DisclosureImprovementsofMajorCDSDealers...............................................................27Figures1.GlobalCreditDerivativesOutstanding..................................................................................42.CDSNotionalOutstanding:Singl-versusMulti-Name.........................................................73.WeeklyCorporateSingle-NameBid/AskedSpread..............................................................74.OTCDerivativeTradeConfirmationsOutstanding...............................................................9Boxes1.ForerunnertotheBigBang:theISDACashOpt-InCDSSettlementProtocol..................112.BasicsofOTCCounterpartyCreditRiskMitigation..........................................................183I.INTRODUCTIONCreditderivativemarketsarelargelyunregulated,butcallsareincreasinglybeingmadeforchangestothis“handsoff”stance,amidstconcernsthattheyhelpedtofuelthecurrentfinancialcrisis,orthattheycouldbeacauseofthenextone.Forexample,intheUnitedStates,marketparticipantshavestructuredtheircreditdefaultswap(CDS)activitiesinaway(individualnegotiation)thatexemptsthemfromregulationbytheCommodityFuturesTradingCommission(CFTC)undertheCommodityFuturesModernizationActof2000(CFMA).2Furthermore,theU.S.SecuritiesandExchangeCommission(SEC)haslimitedauthoritytoenforcefederalsecuritieslaws,includingprohibitionsagainstinsidertrading.Moreover,sincethesetransactionsarenotclearedorsafe-keptinregulatedsecuritiesdepositories,theyareoutsidetheauthorityoftheFederalReserve(Fed).Consequently,untilrecentlyCDStradeswereneitherreportedto,noreffectivelyoverseenbyanypublicauthority.3Thepurposeofthispaperistoaddresstwobasicquestions:Docreditderivativemarketsincreasesystemicrisk,andthusshouldtheybemo