International regulators are increasing the pressure on the financial industry to introduce a clearer system for settling contracts after a corporate default in the $45,000 billion credit derivatives market, the Financial Times reports.
The New York Federal Reserve and the UKs Financial Services Authority are urging industry associations, such as the International Swaps and Derivatives Association, to introduce binding rules about how CDS contracts are settled in default, the FT says. The moves come amid growing expectations that corporate bond default rates will rise sharply in forthcoming years and amid signs that investors are uneasy about the ability of the CDS infrastructure to withstand a wave a defaults.
The volume of the CDS market has increased dramatically in the last decade. The volume of derivatives contracts can sometimes be 10 times bigger than the underlying cash bonds on which the CDS are based, the FT says.
Traditionally counterparties need to get hold of bonds when a default occurs, to pay back investors. The industry has recently used auctions to decide the value of the bonds and then settle the contracts in cash.But this scheme is not formally written into CDS contracts, and has never been used in any large-scale failures or tested in Europe.
The regulators want a more formal settlement system to avoid any potential investor unease. The FSA told the FT that they would welcome private sectors initiatives to improve the market.
Robert Pickel, head of the ISDA, told the FT: Our settlement mechanism is globally applicable but the balance of opinion is to test-drive it for a non-US event. The ISDA is on standby to do this for future trades and was considering introducing a big bang protocol that could be applied retrospectively to existing trades, he said.