Wednesday, November 30, 2011

CDS trade like futures, not like insurance

Bloggers, analysts, consultants out there love to preach about the dangers of sovereign CDS. It's the scary counterparty risk that will bring down the whole system when CDS triggers.
Bloomberg: With banks on both sides of the Atlantic using derivatives to hedge, potential losses aren’t being reduced, said Frederick Cannon, director of research at New York-based investment bank Keefe, Bruyette & Woods Inc.

“Risk isn’t going to evaporate through these trades,” Cannon said. “The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who’s ultimately going to pay for the losses?”
Really?  So what happens when listed equity puts go in-the-money or futures have a violent move?  Actually nothing.  The same is true for standard CDS contracts.  Nothing will happen when they trigger because these contracts are collateralized the same way that futures trading is collateralized with margin adjusted continuously.
RiskCenter: Exposures between two counterparties under an ISDA Master Agreement are typically subject to one of ISDA’s credit support annexes. Our margin survey indicates that over 70% of derivatives exposure is subject to these arrangements. But some of the entities that are users of other types of derivatives ‒ sovereigns, supranationals and corporates ‒ are not active in CDS. As a result, well over 90% of CDS are subject to collateral arrangements, and these arrangements are virtually all two-way (i.e., either party could post collateral to the other based on the mark-to-market value of trades between them).
CDS is not insurance because it gets marked to marked daily.  That means as the credit quality of the underlying name deteriorates, the CDS is marked wider and incremental margin is posted to cover losses - daily.  By the time the CDS triggers, the protection buyer has collected enough margin to cover losses.  This is no different than shorting  puts - the broker will call for margin daily.

It's amazing that many so-called "experts" are not aware of this process and continue to skew both the overall  perception and public policy with their hype.