The reform of European credit default swap market

Frederik Domler, Researcher, University of Warwick. The author first and foremost wishes to acknowledge the valuable comments of Mark Connolley, Partner, Neural Insight Limited, Christopher Jones, Risk Management Director, LCH. Clearnet, Richard Metcalfe, Head of Policy, International Swaps and Derivatives Association, and Mark Austen, Chief Operating Officer and Christian Krohn, Managing Director from the Association for Financial Markets in Europe.

Introduction

Credit default swaps (CDSs) have developed considerably since their inception in 1991. Together with collateralised debt obligations (CDOs), they are considered the most important instrument intransforming global credit markets, experiencing popularity like few other financial instruments, growing in notional amount outstanding from US$632bn H1 2001 US$, to US$8.4trn in H2 2004 to more than US$62trn at its peak in H2 2007 ¹. This tremendous growth combined with the fact that failures of large CDS market players, including two well-known investments banks Lehman Brothers (bankrupt), Bear Stearns (bought by JP Morgan Chase) and the paramount worldwide insurance company AIG (bailed out by the Federal Reserve and Department of Treasury) ², could easily lead to hasty and injudicious conclusions that CDSs are toxic products which should be prohibited or heavily regulated. If the G20’s recent momentum in the political debate surrounding OTC derivatives – and the CDS market is mirrored in the final legislation in Europe and the US, CDSs would in the best case be curtailed and in the worst case eliminated.