The credit default swap market has seen an emphasis on streamlined trading and reduced complexity, making the market easier to participate in and regulate, according to a report from Celent, a Boston-based financial research and consulting firm.

The report, Counterparty Risk in Non-standardized Credit Default Swaps Market, says single-name CDS volume, as a share of notional outstanding volume, has gone up since the second half of 2007 and even exceeded 2006 levels in 2009.

This underlines the important role of non-standardized CDS in the credit derivatives market and highlights the need to deal with counterparty risk for this category.

"The leading banks/dealers in the OTC derivatives markets are the main buyers and sellers of CDS. Hence, the chances of having them as a counterparty are quite high. This circularity within the system increases counterparty risk and we need to tackle it without hampering the market performance," says Anshuman Jaswal , Celent analyst and author of the report. "Importantly, from a regulatory point of view, there should not be a penalty for using non-standardized CDS because they play a crucial role in the efficient functioning of the credit markets. Also, we need to ensure that there is no confusion due to overlap in regulatory powers of different financial regulators, both nationally and internationally."

The report found that credit events, such as bankruptcy, default, or restructuring, have risen sharply in 2008-2009. Celent says in this prevailing climate, measures have to be taken to protect market participants from suffering severe losses due to counterparty risk.
 
It also says the leading banks/dealers in the OTC derivatives markets are the main buyers and sellers, so the chances of having them as a counterparty are quite high. Also, they are among the main non-sovereign reference entities. Additionally, some of them have been bailed out by their governments, which are among the leading sovereign reference entities. Hence, there is a lot of interconnectedness in the CDS that has to be considered while calculating counterparty risk.

There are lower CDS volumes after the crisis for two reasons, according to the report. The first is a reduction in business activity as a result of the credit crisis. Many of the smaller players have exited the market. The second is the end of compression of volumes. In 2008 alone, there was USD30.2trn worth of terminations undertaken by the compression service provider TriOptima.
 
While the volume of index CDS rose after the crisis, single-name CDS continue to be an important part of the market and formed 61 per cent of the overall volume at the end of 2008. Hence, there is a need to address the counterparty risks involved in these non-standard CDS, says Celent.
 
The leading dealers dominate the CDS market, and have around 84 per cent of the volume. This highlights the concentration of the market in the hands of a few players. The concentration increased after the fall of Bear Stearns and Lehman Brothers and the merger of Merrill Lynch with Bank of America.

Celent believes collateral management should be enhanced. In a number of instances involving smaller banks and other players, the level of collateralisation has been found to be low. Almost a third of the credit derivatives transactions have been found to have employed no collateral. 
 


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