ECB calls for more transparency on credit derivatives

August 28, 2009

FRANKFURT, Aug 28 (Reuters) – More disclosure and transparency in credit derivatives is needed to allow better risk management in a market that amounted to over $41 trillion in December 2008, the European Central Bank said on Friday.

In a report on credit default swaps and counterparty risk, the ECB said a lack of information about trading in credit default swaps (CDS) remained a problem. “Greater disclosure and transparency is required for the assessment of systemic risk,” the ECB said.

Areas for improvement included extended disclosure on counterparty risk, differences in data coverage, public disclosure of trading and price transparency.

CDS are over-the-counter bets on whether or not a company will default on its debt.

The report said concentration in the CDS market was now higher than before the financial crisis, because bond insurers, hedge funds, credit derivative product companies and dealers Bear Stearns, Lehman Brothers and Merrill Lynch had dropped out.

“This concentration has increased the liquidity risk in the event of another dealer failure,” as well as led to a scarcity of players willing to sell protection against default, the report said.

The ECB cited data showing that five dealers — JPMorgan, Goldman Sachs, Morgan Stanley, Deutsche Bank and Barclays — were counterparties to almost half of the market.

“The fact that (global) financial institutions are tied to each other through chains of over-the-counter derivative contracts means that the failure of one institution can substantially raise CDS spreads on other institutions, making it difficult to separate the credit risk of the debtor from CDS counterparty risk,” the ECB said.

Before the crisis, global banks were net buyers of protection, the report said. On the other side, it cited Fitch Ratings data from end-2006 showed that AIG <AIGINL.UL> and the bond insurers, also known as monolines, had large negative positions.

Insurer AIG was ranked only 20th-largest player in the CDS market in a 2006 survey, but because it was a one-way protection seller, “AIG proved to be too systemically important for the insurance market and too interconnected to fail,” the ECB said.

As of April 2009, when data for the report was collected, euro area banks were net sellers of protection, although the net amount was small, the report said.

Now that central clearing houses are being established for the CDS market, which will concentrate counterparty risk even more, the ECB said, “it is vital that CCPs operate under appropriate supervisory oversight to ensure that they have sound corporate governance and robust risk management practices”.

The ECB also said the widening in sovereign credit default swap spreads since mid-March had potential policy implications, given that CDS spreads could have an impact on government credit ratings in an illiquid market.

“The possibility of negative feedback loops would thus seem to warrant further research for financial stability monitoring purposes,” the report said.

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