JP Morgan Chase, Goldman Sachs and the eight other banks that have dominated the credit-default swaps (CDS) market for a decade are now ceding some power to their clients as regulators push for transparency.
Pacific Investment Management, Elliott Management and three other investment firms will join ten dealers this week on a committee that will make binding decisions for the first time on how contracts are settled. Such decisions have influenced payouts and, at times, had the potential to almost double the amount investors made or lost.
The committee may help boost confidence in the $28-trillion market, where banks, hedge funds, insurance companies and investors speculate on the creditworthiness of borrowers or hedge against losses on debt. Market decisions, while not binding, were made previously during conference calls between dealers, with no clear rules in place to ensure all sides were being considered.
“It’s largely been seen as a closed-door process in the past,” said Brian Yelvington, an analyst at debt research firm CreditSights in New York. With the committee, “...the transparency and the fact that you should get some consistency gives people a lot more confidence than they’ve had,” he said.
The committee is part of a broader effort being pushed by regulators, including the Federal Reserve Bank of New York, to curb the risk of systemic losses from the privately negotiated market, where outstanding contracts ballooned to as much as $62 trillion at the end of 2007.
The overhaul, dubbed the “Big Bang” because it’s considered a cataclysmic shift for the market, aims to bring a fresh set of standards to existing and new trades.
Rules of the new committee will require an 80 per cent majority among the 15 members before a credit event can be declared. Credit events allow a firm that bought protection against default to demand payment from its counterparty. Matters failing to get an 80 per cent agreement would be sent to a panel of arbitrators.
The International Swaps and Derivatives Association, or ISDA, will serve as secretary of the committee and will be required to publish each matter brought before the committee on its Website, including information on the firm that brought it and how each member of the committee voted.
Market participants “...know that even if they aren’t in the room themselves, they’ll at least understand how the decisions were made and can have more confidence that the decision is correct,” said Jason Quinn, co-head of high-grade and high-yield flow trading at Barclays Capital in New York. Barclays is one of the 10 dealers on the committee.
“The inclusion of buy-side firms makes the process stronger,” Thomas Jasper, chief executive officer of Bermuda- based Primus Guaranty, said in a statement. The firm, which manages about $22 billion in credit-default swaps, is the parent of Primus Asset Management. Spokespeople for the other firms didn’t return calls for comment, declined to comment or couldn’t immediately be reached.
The other dealers with votes on the committee for US and European markets are Deutsche Bank, Morgan Stanley, Bank of America, UBS, Citigroup, Credit Suisse and Royal Bank of Scotland.
The 2,023 entities that had signed up as of late yesterday in New York, as measured by the ISDA, will agree to abide by the committee’s decisions and auctions that determine the value of underlying securities. The auctions effectively set the size of the payout when borrowers default.
Both the auction and the credit-swaps committee are necessary for another effort pushed by regulators: moving the derivatives through clearing houses designed to absorb the failure of a dealer collapse.
Without a panel to make binding decisions, clearing houses would be at risk of having a firm on one side of a trade disputing a so-called credit event, while the other side demands payment. After more than a week of debating, dealers last month overruled some objections and declared a credit event for contracts guaranteeing the debt of a unit of Montreal-based AbitibiBowater, North America’s biggest newsprint maker.
Credit-default swaps pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent.
The US Fed began pushing for clearing houses last year after the near-collapse of Bear Stearns in March 2008 and the failure of Lehman Brothers Holdings in September triggered concerns that banks were too interconnected.
Dealers probably lost “hundreds of millions” of dollars because of failed trades with Lehman, Moody’s Investors Service said last year. Lehman’s collapse also triggered a panic that other firms could fail, prompting the US to provide capital to the nine biggest banks and guarantee new debt for three years.
