Traders Moved Credit Derivatives Positions Ahead of Lehman’s Bankruptcy Sep 16, 2008 URL: http://www.advancedtrading.com/showArticle.jhtml?articleID=210602000
As regulators met around the clock last weekend to sort out Lehman's future, the OTC derivatives world faced another test — reducing its exposure to the investment bank as a counterparty in credit default swaps.
Credit default swap traders headed into the office on Saturday to evaluate their exposures to Lehman Brothers, according to media reports.
"Traders who had credit default positions with Lehman Brothers as a counterparty started to transfer the transactions to other dealers last week before anybody knew the outcome of the investment bank's credit crisis," says Kevin McPartland, senior analyst at TABB Group.
Lehman was said to be a major player in the CDS market, just as Bear Stearns was, before the firm's counterparties tried to unwind their positions and transfer the contacts to other dealers. Lehman clients, including hedge funds, did trim positions last week.
"The International Swaps and Derivatives Association staged an emergency trading session on Sunday to allow dealers to prepare for the death of Lehman Brothers, a fairly large player," reported the Financial Times on Monday.
According to Rob Hegarty, managing director of TowerGroup's securities & investments and insurance practices, "There were credit default swaps changing hands ahead of Lehman's bankruptcy and that was all in anticipation of whether Lehman was going to default on payment or go into bankruptcy."
However, since the CDS market is traded over the counter between dealers and not on an exchange, there is less transparency into the positions and who owns what. "As we're seeing with AIG, another big player in the CDS market, because [CDSs] are not exchange-listed or highly liquid in most cases, the entire integrity of the instrument is based on your counterparty," says Hegarty. "That's why everyone gets very jumpy when a market like this collapses," he says.
An article in the weekend edition of the Wall Street Journal, however, suggested that firms might be willing to disclose their positions to each other because if they hold similar contracts with Lehman they could unwind them and become counterparties to each other.
Those who are on the other side of CDS trades with Lehman Brothers were trying to shift their positions to other dealers through a process known as novation, which occurs via e-mail.
"People who had Lehman on the other side didn't feel comfortable that Lehman could meet its obligations, and they wanted to novate, or transfer, the contract to someone else," says TABB's McPartland.
ISDA established the novation protocol in 2005, recalls McPartland, who recently authored a report titled, "Credit Default Swaps: The Risk of Inefficient Markets." "In the CDS world, novating a trade amounts to changing the counterparty on the other side of the agreement," writes the analyst in the report.
The novation protocol established by ISDA moved novation from a phone-based to an e-mail-based process. However, the dealers have said they would move the novation process to an automated solution by the end of 2008, notes McPartland.
A July 31 letter from the Operations Management Group, representing the major dealers and buy-side institutions, to the Federal Reserve Bank of New York laid out all the deadlines for automating OTC derivatives transactions. According to the letter, all market participants are required to submit and manage novation requests for electronically eligible trades via electronic processing platforms as of Dec. 31, 2008.
Although automation technology currently is live, "We still have a huge chunk of e-mail for novations in place," McPartland says. What's more, novation is a complicated process that takes place in two stages, he adds. Say Firm A is in a transaction with Firm B and wants to shift the counterparty to Firm C, explains McPartland. First, Firm A has to send a termination notice to Firm B to cancel and then a new notice to Firm C. "You need approvals from all the parities before it can be officially completed," says McPartland. What makes it more complicated is that firms are waiting for all these approvals.
If the process were automated, someone could novate a CDS with the front end of an order management system, McPartland suggests. "They could make the changes to the trade on a screen, and a central network could send electronic notices to the existing counterparty and the new counterparty, and message responses could be sent through a central hub," he explains. "They could see who responded and see the messages in real time and see the notices through the system. It ends up providing a lot more transparency into the novation process," he says.
Meanwhile, all the turmoil is occurring at a time when regulators have been pushing the major dealers to automate the trade processing of OTC derivatives and reduce operational risk, starting with credit defaults swaps.
"The now-famous confirmation backlog was born from stacks of FAX paper crying out for attention," writes McPartland in his report. Major dealers have made substantial progress in cleaning up the backlog of unconfirmed trades for CDSs, he notes.
More than 90 percent of credit derivative swaps are confirmed through the DTCC's DerivServ electronic matching facility. However, according to Markit, a supplier of solutions for OTC derivaitves trade processing, about 50 percent of the rest of the market in interest-rate and equity-derivatives is still confirmed on paper.
"The industry has made a lot of progress in improving processing and risk management and knowing what they're exposure is," says TABB's McPartland. "People were not left saying, 'Oh, no, I don't know what our exposures are.' That might be why there is a slightly different feel here," says the analyst.
Even though dealers may have successfully reduced their exposure to CDS contracts with Lehman, the industry is not out of the woods yet, cautions TowerGroup's Hegarty. "Whether it's Lehman or an airline, as these companies get into precarious credit positions, the likelihood of their defaulting on an interest-rate payment of a bond increases," he says.