Thursday, October 09, 2008

CDS Systemic Risk

CDS Systemic risk: a primer about chain settlement risk.

An easy explanation of some theoretical problems with CDSs (and I am not sure this is the real and biggest problem with CDSs). But when you have CDS coverage of USD 60 trillion floating around, this also might be a real practical problem all too soon.
A grossly simplified example will explain it. Party A wishes to place a bet on Frannie default risk by purchasing CDS protection on Frannie. Party A buys protection from B. B is now exposed to the risk of a Frannie default and decides to hedge this risk by buying Frannie CDS protection from party C. C holds the position with net exposure for awhile, gets nervous and then offsets by purchasing protection from Party D, who then offsets the exposure with Party E.

For the sake of simplicity we will assume the default event of Frannie requires $10m in cash or securities to be delivered within 5 business days of the acknowledged default event. Now all of the parties involved have done their risk assessments of their downstream counterparty using various estimates of the counterparties credit quality and liquidity. They have each come to the conclusion, that their next counterparty has a .001% chance of failure at any point in time. They could thus assess the counterparty risk exposure in crude nominal terms as being $10mx 0.01% = $1,000. This feels safe.

Looking individually each party assumes they have $1,000 in risk. In reality A faces $4,000 in probable risk. The chain is only as strong as it weakest link. The end settlement party A has $4,000 exposure (1-(1-.0001)^4)*$1,000. Party B has a $3,000 exposure etc. The longer the chain the greater the systemic risk for the initiator and the potential for a failure to deliver on time etc.

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