CDS Reform Proposals: I Don't Get It

Bloomberg has reported:

For the first time, the market will have a committee of banks and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get, industry leaders said yesterday at a conference in New York. Traders also will revamp the way the contracts are traded, including requiring upfront payments to make them more like the bonds they’re linked to.

The plan doesn’t change contracts traded in Europe.

In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. Now, upfront payments are only required for riskier companies, and the annual payment, or coupon, on most contracts is determined by the daily market level.

Dealbreaker, bless its heart, is contemptuous:

We are looking forward to the world where the only finance products permitted go up forever, and where everyone makes above average returns.

I’m mainly confused, and hoping that the Bloomberg reporters simply got it wrong. A standard up-front fee for the buyers of protection? It makes no sense. The buyer’s risk is limited to the sum of the present value of the payments required. A five year contract with a 5% premium limits the buyer’s potential loss to 25% of the notional value. The tail risk of the contract is owned by the seller of the protection, who can lose 100% of notional on the very first day the contract is in existence.

Selling protection has capital implications roughly equivalent to owning the bond. I have no problem with the idea that CDS sellers post margin equivalent to what they would have to were the position an actual bond – but most of them do already. The trouble started when the AIGs and MBIAs of this world sold protection without posting collateral or taking a high enough capital charge for regulatory purposes.

And what’s this with a fixed standard rate of $100,000 or $500,000 per year for the premium (paid by the buyer to the seller) on $10-million notional? That’s 1% and 5%, respectively. I can see that it might be very useful to standardize tick sizes, so that all contracts will trade with, say 10bp ticks … but those premia don’t make any sense.

Note that with 10bp ticks (any size ticks, actually), virtually every contract would have a value at the opening, which would be settled by cash payment between buyer and seller at the time the contract is written. I don’t have any problems with that idea – it would make contracts more fungible, particularly if settled by a clearinghouse.

But we are in the hysteria phase of CDS demonization and the politicians need a pulpit. ISDA has released a mild demur – I can only hope they’re more vociferous behind closed doors.

It was announced yesterday that JPMorgan’s analytics will go open-source; but no details of licensing have yet been released.

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