Yesterday, the Senior Supervisors Group, which consists of the senior financial supervisors from the U.S., U.K., Canada, France, Germany, Japan and Switzerland, released a report entitled “Observations on Management of Recent Credit Default Swap Credit Events.” This report summarizes the results of a review initiated by the group in December 2008 to assesses “how firms manage their credit default swap (CDS) activities related to the settlement of credit derivatives transactions terminated by the occurrence of a credit event.” The review of management of CDS credit events was undertaken to support priorities published in a report by the Financial Stability Forum last April, which included enhancing the over-the-counter derivatives market infrastructure and “encouraging market participants to act promptly to ensure that the settlement, legal, and operational infrastructure underlying these markets is sound.”

Discussions with senior members of twelve institutions, including major dealers, buy-side firms, service providers, and an industry association, indicate that settlement of CDS as a result of recent credit events was managed in an orderly fashion, “with high participation rates and no major operational disruptions or liquidity problems.” The review generally confirmed the effectiveness of the auction-based settlement mechanism currently used for CDS on significant reference entities. The following conclusions were reached in the review:

  • Market participant support of the International Swaps and Derivatives Association’s (ISDA) publication of the auction supplement to its 2003 Credit Derivatives Definitions and the publication of a “big bang” protocol will assist in reducing uncertainty, increasing participation and enhancing the efficiency of credit event management.
  • Maintaining accurate CDS counterparty exposure data and all CDS trade information in one centralized infrastructure will enable firms to more easily identify affected trades and will facilitate the handling of various lifecycle events, such as settlement and credit event processing. Progress has been made on this initiative, as firms are continuing to load existing CDS client trades into the Depository Trust & Clearing Corporation’s (DTCC) Trade Information Warehouse (TIW), allowing them to utilize its credit event processing platform, conduct central settlement, “facilitate cash settlement of CDS trades and maximize the benefits of multilateral netting among counterparties.”
  • Engaging all market participants in decision-making with regard to all phases of the credit event management process will serve to “promote a broader market consensus and encourage more equitable market prices.”
  • Operational risk associated with auctions can be reduced by formalizing market-wide and internal procedures, periodic reevaluation and enhancement of the auction process.
  • Firms should invest in the necessary operational infrastructure and training resources for credit event management to “assure efficiency, accuracy, and timeliness of CDS settlement.”