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date: 16 July 2019

Non-Technical Introduction

Abstract and Keywords

This article discusses the development of the credit derivatives concept and how it became increasingly controversial, especially during the banking crisis of 2007 and 2008. In the fifteen years since the concept was first developed, by groups such as J. P. Morgan, Bankers Trust, Credit Suisse – and others – this product has expanded with dizzying speed. At the start of the decade, official data from ISDA suggested that barely $1 trillion of these contracts had been written in the global markets when measured in terms of gross outstanding amount (i.e., without netting off contracts which offset each other). By 2008, that sum had swelled above $60 trillion. More striking still, the original concept of credit derivatives had mutated into numerous new forms, breeding a host of acronyms along the way covering corporate, sovereign, and mortgage debt.

Keywords: credit derivatives, banking crisis, J. P. Morgan, corporate debt, sovereign debt, mortgage debt

Back in the mid 1990s, a regulator working for America's Office of the Comptroller of the Currency (OCC) encountered some marketing literature from J. P. Morgan bank which described the concept of credit derivatives. Back then, the idea seemed extraordinarily novel. However, this particular regulator was both surprised and thrilled. ‘It seemed to me that this was one of the most important innovations that had occurred for years,’ he later recalled, adding that he immediately called the J. P. Morgan bankers to express his enthusiasm. ‘The whole concept of credit derivatives seemed wonderful—such a clever way to reduce systemic risk!’

These days, this particular American financial official is now wondering, as he says, ‘how it all just went so wrong’. So are many other investors, bankers, and government officials. In the fifteen years since the credit derivatives concept was first developed by groups such as J. P. Morgan, Bankers Trust, Credit Suisse—and others—this product has expanded with dizzying speed. At the start of the decade, official data from ISDA suggested that barely $1 trillion of these contracts had been written in the global markets when measured in terms of gross outstanding amount (i.e. without netting off contracts which offset each other). By 2008, that sum had swelled above $60 trillion. More striking still, the original concept of credit derivatives had mutated into numerous new forms, breeding a host of acronyms along the way covering corporate, sovereign, and mortgage debt.

But as the concept has taken root, it has become increasingly controversial. Most notably, during the banking crisis of 2007 and 2008, some regulators, bankers, and investors blamed credit derivatives instruments for contributing to the financial woes. More specifically, these products are perceived to have exacerbated the credit bubble on the ‘way up’ by concealing the scale of leverage in the system and amplifying risk taking. Worse still, credit derivatives also made it harder for policy makers to contain the shock when the bubble burst, because the opacity of the sector made it hard to identify developing risks—and these contracts had interwoven different institutions (p. 4) in a complex mesh of exposures, creating the so-called ‘too interconnected to fail’ woes. Thus, during 2009 there has been a plethora of hand-wringing about credit derivatives—and a new global drive to subject these instruments to new regulatory controls.

Some bankers insist that these criticisms of credit derivatives are grossly unfair. After all, they argue, the real source of the credit bubble during the early years of this decade was not the credit derivatives technology per se, but the flood of cheap money, as a result of excessively loose monetary policy, and poor regulation of sectors such as the mortgage industry. Moreover, these defenders would add, it was not the credit derivatives market alone which created the ‘too interconnected to fail’ headache (or the idea that it was impossible for governments to let any big bank collapse, since it would have repercussions for everybody else, due to counterparty risk). The structure of the tri-party repurchase market, for example, also played a key role in the financial panic of 2008. So did accounting rules.

Nevertheless, such pleading by the banking industry has not deterred the criticism. Consequently, as the debate about the culpability of credit derivatives rages on, the one thing that is crystal clear is that the whole concept of credit derivatives has now become more high profile than most bankers ever dreamt. Whereas the details of this market used to only arouse interest among financial experts, they have now been splashed across newspapers and prime-time television shows in America and the UK. The topic has even provoked political debate in Washington and Brussels. And that in turn has prompted observers both inside and outside the banking world to ask new questions about the product; most notably about where the idea first erupted from. And where it might now be heading, after the recent controversy.

Identifying the source of the credit derivatives idea is not easy. After all, finance is not a field of activity swathed with patents or intellectual copyrights: instead, ideas tend to swirl around the markets, to be endlessly copied, improved, and advanced, making it hard for any one individual—or bank—to ever claim true ‘authorship’ of an idea. Arguably the first place where credit derivatives deals appeared was at Bankers Trust bank in New York, where a small team of bankers, including Peter Freund and John Crystal, first cut a couple of rudimentary deals in 1991. These essentially took the concept that had been central to the previous derivative products—namely using tailor-made contracts to ‘swap’ exposures, say, to fixed and floating rates or currencies—and applied it to the field of credit risk. Essentially, that meant that one party promised to compensate another party if a bond (or loan) went into default—in exchange for a predetermined fee. What was being ‘swapped’, in other words, was a fixed fee and an exposure to default risk, in a private, off-exchange deal between two parties.

Initially, this brainchild did not appear to cause much of a splash, either inside or outside Bankers Trust. Freund's team did not immediately see any way to make the concept yield significant profits or fees for their bank (or not, at least, compared to the plethora of innovative interest rate products which were being developed in the market at the time). And that, coupled with personnel changes, deterred them from allocating too many resources to the idea, leaving the field clear for other rivals.

(p. 5) One of those—and the most important early player in the credit derivatives field—was J. P. Morgan bank. During the 1980s and early 1990s, the bank had developed a large interest and foreign exchange derivatives business, and by the mid-1990s it was seeking ways to expand this. Under the leadership of men such as Peter Hancock and Bill Demchak, long-time employees of J. P. Morgan, the bank decided it would be worthwhile to pursue the credit derivatives idea, even if it did not appear to be an immediate source of client or proprietary profits. This was partly because J. P. Morgan, as a large corporate lender, had a natural expertise in corporate debt, and a large stable of corporate clients. The bank also had a huge regulatory incentive: in the early 1990s, the bank's top management had realized that they needed to remove credit risk from J. P. Morgan's book and to use its economic and regulatory capital more efficiently. However, they did not wish to do this through ‘simple’ loan sales that could undermine client relationships. Developing synthetic swaps thus appeared to be an attractive way to remove credit risk, while preserving a lending franchise.

The young bankers at J. P. Morgan also argued that there could also be wider systemic benefits to the idea, beyond anything that pertained to their bank. If banks such as J. P. Morgan started shedding credit risk, they suggested, that would enable them to reduce the type of risk concentrations that had hurt commercial lenders in previous economic cycles, such as during the Savings and Loans crisis of the late 1980s. A new era of banking would dawn, where banks were diversified and hedged in a way that would make the financial system stronger; or so the theory went. And for the most part the theory was one that was enthusiastically accepted by regulators, not just at the OCC, but by the US Federal Reserve as well as their European counterpart. That, in turn, helped to create a benign regulatory climate for the new instruments.

The first set of products that the J. P. Morgan group developed in the early and mid-1990s were fairly ad hoc credit derivatives, based on contracts that traded the credit risk on individual companies or sovereign entities, ranging from Exxon to the Korean Development bank. Other banks quickly copied the contracts, which were mostly arranged in the form of credit default swaps (CDS). But then, bankers started to bundle multiple different credit risks together, in a variety of different structures, to enable participants to shift credit risk on a larger scale (and investors to further diversify their exposures). By 1997, Swiss Bank, Chase Manhattan, Merrill Lynch, and Credit Suisse, for example, were all playing around with variants of this idea, using leveraged loans, corporate bonds, and sovereign credit. Then in late 1997, the J. P. Morgan team in London launched a particularly eye-catching product that came to be known as ‘Bistro’. This scheme, which was technically short for ‘Broad Secured Trust Offering’—but was also known as ‘BIS total rip off’ on the J. P. Morgan desk, since it appeared to run rings around the bank capital rules devised by the Bank of International Settlements—essentially bundled together dozens of corporate credits into a single structure, and removed these from the balance sheet of J. P. Morgan. It did this by transferring the risk to a special purpose vehicle, funded through the sale of bonds to third party investors, carrying different tranches of risk. In some respects that reflected similar structures created by groups such as Swiss Bank, but what made (p. 6) the Bistro scheme path-breaking was that the SPV did not fund itself fully; on the contrary, barely $700million of funds were raised, to support a $10-odd billion credit portfolio. This made it significantly cheaper to arrange than previous schemes. The scheme was still able to get a top-notch rating from the credit rating agencies, since these presumed that the loans were of such good quality that it was extremely unlikely that there would be enough defaults to wipe out the $700m-odd cushion. The net result was that J. P. Morgan could to dance more effectively around the BIS rules.

The concept quickly caught on, spawning dozens of similar offerings, which subsequently came to be known as ‘synthetic collateralized debt obligations’. As the ratings agencies spotted a lucrative new line of business, they supported these new products by providing the all-important ‘triple A’ stamp for the deals, thus enabling the banks to keep dancing around the Basel rules on a growing scale. Then, in the early years of the new decade, bankers took the ‘Bistro’ concept a step further, developing so-called ‘single tranche’ collateralized debt obligations (CDOs)(deals where one tranche was funded, but not necessarily the most senior tranche). The practice of trading single-name CDS—or those written on individual companies, rather than bundled together— rapidly expanded too, particularly in Europe, as events such as the 1998 Asian financial crisis and collapse of the internet boom sparked more investor interest in the idea of hedging credit risk. Then in the early years of the new decade, bankers at the newly merged JPMorgan Chase, along with those at Deutsche Bank, Morgan Stanley, and elsewhere, launched so-called tradeable credit derivatives indices. These essentially offered a price for a basket of credit default swaps—but also provided a contract that could be traded in its own right. Since these products were more liquid and transparent than single name CDS, they attracted a wider pool of investors. These items also provided crucial reference points for structures such as single tranche CDOs. These innovations turbo-charged the market: between 2000 and 2003, ISDA estimated that the gross notional outstanding value of trades more than tripled to around $3 trillion, and then increased fivefold in the next two years.

The other reason why the market exploded was the wider macroeconomic climate. After the collapse of the telecoms bubble in 2001, Alan Greenspan, chairman of the US Federal Reserve, slashed short-term interest rates. At the same time, a savings surplus in Asia helped to drive long-term yields down in the government bond market too. Taken together, that spurred investors to seek new ways to increase their returns, most notably by turning to derivatives, increasing credit risk, and using dramatically higher levels of leverage. Banks also expanded the scope of products involved in the credit derivatives business. Back in the mid-1990s, when the CDS concept had first sprung to life, bankers at J. P. Morgan had not generally sought to apply the idea to residential mortgages, since that was not an area of the bank's expertise. Furthermore, someJ.P. Morgan bankers were wary of trying tomodel the risk in the housing market, since they feared that there was not enough reliable data on what might happen in a house price crash to give good calculations for the price of the tranches of a CDO linked to mortgage risk.

(p. 7) From the late 1990s onwards, however, other banks started to play around with the concept of using mortgage risk. That was partly because there was strong investor appetite for mortgage debt in the wake of the telecoms crash, since the housing markets—unlike the corporate sector—had not generally been hurt by that crash. Some bankers and investors were also attracted by the idea of using derivatives technology in the mortgage world since it appeared to offer more flexibility than the traditional practice of bundling mortgage bonds together via cash CDOs. More specifically, by 2005 there was strong investor demand for products composed of sub-prime mortgage securities, which paid (relatively) good returns—but not enough sub-prime loans to meet that demand. Thus, instead of building CDOs from tangible mortgage bonds, bankers increasingly turned to derivatives instead, to overcome the shortage. And those endeavours were given a big boost when a tradeable index of mortgage derivatives was launched at the start of 2006. This new index, run by Markit, was known as the ‘ABX’ series and designed to complement the other corporate and loan credit derivatives indices, known respectively as iTraxx (European corporate credit), CDX (American corporate credit), and LCDX (leverage loans.)

The net result of all these trends was a further boom in the scale and complexity of the credit derivatives world. As the product expanded, a subtle—but crucially important—shift occurred in the nature of the market. Back in the early 1990s, when concepts such as Bistro or single-name CDS had first emerged, these instruments had generally been presented and perceived as hedging tools, rather than having a purpose that was primarily speculative. In reality, of course, speculation always played a role; it is impossible to have hedging in any market, unless somebody is willing to take a risk. The key reason why groups such as the OCC—and other regulators—initially backed the idea of credit derivatives so enthusiastically was that they believed this hedging incentive was dominant, hence their enthusiasm for viewing credit derivatives as a tool to mitigate systemic risk.

However, by the middle of the new decade, this ‘hedging’ function of the market became overwhelmed by speculative practices and motives. Surveys by the OCC, for example, showed that banks were no longer simply writing CDS to hedge against the default risk of credits which they held on their books, but taking net short positions in credits they did not hold, either for themselves or clients. Numerous other investors were doing the same. Conversely, investors, such as hedge funds, were writing protection as a way to get long in booming markets, such as sub-prime securities. In reality, it was far from clear that all those new investors had sufficient resources to actually honour all those insurance claims, if there was a massive wave of defaults. But, the hedge funds were happy to take the fees for writing insurance, via credit derivatives; and banks (and others) often seemed almost indifferent to the quality of their counterparties, since CDS contracts were increasingly being used to gain regulatory relief, rather than provide genuine economic protection. The product, in other words, was becoming more and more of a tool for speculation and regulatory arbitrage, than a genuine source of credit hedging.

(p. 8) These subtle shifts alarmed some regulators. The Bank for International Settlements, for example, started warning other banking officials as early as 2003 that the explosive pace of growth in the CDS sector, coupled with its opacity, could pose a systemic risk. They also pointed out that these instruments could create moral hazard: since instruments such as CDS appeared to provide such an easy way for banks to hedge their risks, there was no less incentive for lenders to restrict credit or monitor credit quality. However, it was hard for the BIS, or other naysayers, to argue their case in a truly compelling manner, since there was a paucity of data—not least because these contracts were being concluded via private, Over-The-Counter deals, not on the exchange. Meanwhile, groups such as the US Federal Reserve tended to brush off concerns, since men such as Greenspan strongly believed that the credit derivatives boom had made the system far safer than before, as it enabled banks to diversify their credit risks. Greenspan (and others) also tended to assume that free markets were self-correcting and market participants would have a rational incentive to demand rational systems for trading risks; thus even if some excesses were developing in the CDS space, the argument went, bankers themselves should be able to correct them— precisely because the innovation had enabled credit risk to be traded in a more purely free-market manner than ever before.

In many respects, the Fed (and others) appeared to have history firmly on their side, as they presented those arguments. From 2000 onwards, financial markets were beset by a series of shocks, including the bursting of the telecoms bubble, the attack on the World Trade Centre, Enron scandal, failure of WorldCom, Parmalat scandal, the credit ratings agency downgrade of Ford and General Motors—and then the implosion of Amaranth hedge fund. Between 2000 and 2007, the banking system absorbed these blows relatively smoothly, without any large collapses. Regulators generally attributed that to the fact that banks had successfully hedged their credit exposures, using CDS (alongside other tools such as loan sales). Credit derivatives thus seemed to have produced a safer system—just as the J. P. Morgan bankers had once claimed (and the OCC regulators hoped).

In reality, there were two terrible paradoxes sitting at the very heart of the system. One was the fact that while credit derivatives had been developed under the mantra of ‘market completion’ (or to promote liquid free markets for credit and credit risk), by the middle of the new decade many of the products had quietly become so complex that they were not actually being traded at all. Single-name CDS contracts often traded, and the index products were generally very liquid, but bespoke tranches of synthetic CDOs generally did not trade freely. Consequently, when banks and investors tried to value these instruments in their own books they were forced to use models to extrapolate prices from other reference points, since there was no true ‘market’ price available.

That pattern was not, of course, unique to CDS: cash bonds are often illiquid too, but the scale of the CDS boom, and its opacity, created huge opportunities for canny traders not just to engage in forms of economic arbitrage, but to arbitrage their own banks' accounting systems and the wider regulatory framework too. One tactic used by (p. 9) traders at some banks during 2005 and 2006, for example, was to enter a relatively low ‘model’ price for a synthetic product at the start of the year, and to then revalue it at a higher price later in the year—meaning that the difference could be booked as profit for the desk (and thus counted towards the bonus). Observers outside those trading desks (such as risk officers) often found it difficult to challenge this, since the sector was so complex and opaque, and there were no easily tradeable reference points. And that, in turn, had another crucial implication: since banks were relying on ‘model’ prices, and not market prices, there was a lack of the type of true price signals that would have allowed the sector to adjust to changing circumstances—or ‘self-correct’—as men such as Greenspan presumed it should.

The case of super-senior tranches of CDOs was a case in point. The idea of ‘super-senior’ piece of debt first cropped up in the original J. P. Morgan Bistro trade, when the phrase was used to refer to the unfunded portion of the structure which was supposed to be so extraordinarily safe that it could never default (and thus, by implication, even safer than triple A debt). But by the middle of the next decade, the phrase was being used in a loose manner to refer to the safest, and most highly rated chunk of a synthetic CDO, or a credit derivatives contract offering protection against the default of an ultra-safe chunk of debt. Initially, during the early years of the synthetic boom, banks had tried to sell that piece of super-senior debt to other investors, particularly when they were assembling bundles of debt for a third party. Insurance groups such as AIG, for example, were often willing to buy super-senior credit derivatives (or write protection), since, while the yield was low, AIG did not have to hold much capital against these positions. The deals thus provided a reasonably stable source of income.

By the middle of the decade, however, spreads in the credit market were collapsing so far that it was becoming extremely difficult for bankers to find a way to make all the different tranches of a CDO ‘pay their way’. If they structured the deal to ensure that the junior pieces of debt carried enough yield to be attractive to investors, then the returns on super-senior were so paltry they were was hard to sell. To make matters worse, the scale of CDO activity was rising so fast, that there was a glut of super-senior debt on the market. If a fully fledged, transparent secondary liquid market had existed for the tranches, this problem might have been apparent relatively quickly; but, as the price signals were so distorted, it was not—and the CDO boom simply became more, not less intense. So, partly as a result—and for lack of alternative buyers—banks started to stockpile CDO tranches on their own balance sheets. At some banks (such as Merrill Lynch) this was viewed as merely a temporary tactic, to ensure that a pipeline of deals could be completed; at other groups (such as UBS) this stockpiling came to be regarded as a deliberate strategy. (UBS bankers were able to arbitrage the internal risk and pricing models and use cheap sources of capital to keep ‘booking’ profits on the super-senior structures, even as the risk in these exposures disappeared from management reports.)

This pattern then produced a second, even more important paradox: namely that as banks stockpiled CDOs, or super-senior exposures, risks started to be concentrated back onto the banks' books—rather than dispersed across the system, as the original (p. 10) supports of the credit derivatives revolution had expected. As AIG acquired vast quantities of seemingly safe super-senior mortgage risk, for example, it was also becoming increasingly exposed to a highly correlated book of systemic risk. So were banks such as UBS, Merrill Lynch, and Citi, to name but a few. And, just to make matters worse, large banks were often acting as counterparties to each others' deals—and the reference names in these deals were often large financial institutions too.

Moreover, as banks started concentrating the risks back on their own books, another, more subtle form of concentration was occurring inside the deals as well. When the J. P. Morgan bankers had first created synthetic CDOs back in the late 1990s, they had done so assuming that the baskets of credits were diversified, and thus that the level of correlation between corporate defaults was not too high. Those assumptions had also been baked into the approaches used by rating agencies to model the deals. However, as bankers started to use mortgage credit instead of corporate credit for these deals, the pattern of correlation changed. Most notably, although many analysts presumed that the deals would provide diversification, because they included mortgages from different regions of America or mortgage pools; in practice the mortgages tended to be structured in such a similar manner that default correlations were relatively high. If the cost of servicing a mortgage rose above a certain threshold, or the house prices fell, then borrowers were apt to default wherever they lived. Worse still, when bankers started to create CDOs of CDOs, these concentrations tended to be intensified. The ratings agencies generally continued to provide high ratings for these deals, since they lacked the resources—and the incentives—to track the way the mortgage market was changing, and the impact this was having on potential default correlations.

From time to time during 2005 and 2006, as the credit boom grew wilder, some regulators expressed unease in general terms about the nature of the credit boom. In the spring of 2007, for example, the Bank of England observed in a half-yearly financial stability report that it seemed odd that banks' balance sheets were growing—even though they claimed to be shedding credit risk. Timothy Geithner, then head of the New York Federal Reserve, warned on several occasions that some market participants appeared excessively complacent about so-called ‘tail risks’, or the danger that losses could occur which would be so extreme that they would hurt even ‘safe’ debt, and activate credit derivatives. However, the main focus of the regulatory community during this period in relation to credit derivatives was on trading and settlement processes. By 2005, men such as Geithner had realized that the speed of expansion in the CDS sphere had overwhelmed the banks' back offices due to a dire lack of resources. That was leaving deals uncompleted for days, if not weeks, which threatened to create a dangerous legal quagmire if any counterparties ever failed. Thus, from 2005 onwards, British and American regulators exhorted the banks to overhaul their back office procedures, and threatened to impose sanctions on the banks if they did not comply. And the campaign paid off: by 2007, the back office systems at most banks and hedge funds had been radically upgraded. But—ironically enough—amid all the debate about trading systems, there was minimal discussion about the tangible impact (p. 11) of all the new CDS contracts that were being cut through these systems. Thus very few observers noticed that a tool which was supposed to mitigate systemic risk had now spread a whole new range of risks. Even fewer realized that beneath the mantra of risk dispersion, the sector was becoming marked by a growing risk concentration and correlation.

The deadly consequences of this pattern became clear during 2007 and 2008. In early 2007, a bubble in sub-prime lending started to burst. Ironically—or perhaps appropriately—one of the first places where this shift was signalled was in the ABX index: from early 2007, this started to move in a manner that implied that the cost of purchasing protection against a default of a sub-prime bond was rising sharply. Until mid-2007 relatively few non-specialists had ever paid much attention to the ABX (not least since it had only been launched in early 2006), but the price swings had a stealthy domino effect: during 2005 and 2006, many banks and investment groups had used the ABX index and credit ratings as key inputs for the models that they were using to value CDOs and complex derivatives. Thus, as the ABX began to move, financial institutions were forced to start revaluing their assets downwards. Around the same time, the rating agencies started—belatedly—to cut their ratings for mortgage-linked products. That caused prices to fall further. And since many institutions had taken on huge levels of leverage in 2006, that downward revaluation had a devastating impact.

Two highly leveraged hedge funds linked to Bear Stearns were one of the first visible casualties: in midsummer 2007, they both imploded, largely due to swings in the ABX index and other CDO products. Within months a host of other institutions came under pressure too, ranging from hedge funds to major Wall Street banks, and European groups, such as IKB. As share prices in the financial sector tumbled, that sowed panic. That sense of fear was exacerbated by a second, more subtle development: counterparties rushed to hedge their exposures to banks, by using single-name credit derivatives, which then caused the price of those CDS contracts to swing. On one level, this appeared to be an entirely encouraging development, since it reaffirmed the original ‘hedging’ function of the instrument. In another sense, though, the development worsened the panic, since the CDS spread provided a readily available way to gauge the level of investor concern about default risk, and also provided an easy way for investors to bet on a potential bank collapse. Moreover, since it had become common practice from the middle of the decade onwards to use CDS spreads as a way to decide the price of bank debt, the rising CDS spreads also pushed up funding costs—creating a vicious circle of pressure for the banks.

Of course, the CDS market was not the only place where these signs of stress were emerging, and being exacerbated: the slump in the equity markets and the rising cost of finance in the interbank sector were also playing key roles. What made the patterns in the CDS sector particularly notable—and controversial—was the relatively level of opacity in this sphere. Ever since it had first sprung to life, the CDS market had been a private, over-the-counter market. As a result, by 2007, it was still hard for regulators (or anybody else) to get accurate data on trading volumes, counterparties, or even intra-day prices—in notable contrast to the situation in, say, the equity markets. Until (p. 12) 2007, that state of affairs had not prompted much comment, since regulators had generally appeared content to leave the sector as a lightly regulated, OTC business. During the 1990s, the Commodities and Futures Exchange had made a few attempts to pull the sector into its regulatory net, and force it onto exchanges, as part of a wider move to take control of the OTC derivatives sector. This was firmly rebuffed by Greenspan and others, and during the first seven years of the new century there was a widespread consensus—in keeping with the dominant free-market ideology of the times—that CDS should be left lightly regulated, in the OTC sphere.

As the swing in CDS prices began to have wider implications in the autumn of 2007, regulatory scrutiny started to rise. Politicians started to question the way that ratings agencies had rated products during the credit boom, and call for reform of the ratings sector. Concerns were voiced about the way that, say, the ABX sector was managed, since the movements in the index were having a big impact on banks— but it was unclear just how deep the market was, or whether there was any scope for market manipulation, or not. Then a second issue emerged, which further provoked regulatory unease: banks (and other investors) began to worry about counterparty risk. Most notably, since CDS trades were typically settled via bilateral deals, without a centralized counterparty, investors did not have any third party involved in the market to settle trades if one counterparty failed. Since the late 1990s, groups such as ISDA had sought to mitigate that risk by demanding that counterparties post collateral to cover any potential losses if a counterparty did fail—in much the same way that collateral was used in a range of other OTC derivatives deals. Credit derivatives, though—unlike interest rates swaps—have a binary nature: either an entity has gone into default, or not. Thus, whereas counterparties to an interest swap might be able to adjust collateral positions in a gradual manner to reflect changing risks, some market players feared this would prove harder for CDS contracts.

The implosion of Bear Stearns in the spring of 2008 then dramatically raised the level of market concern about those two issues. In the run-up to the dramatic crisis at the broker, the cost of buying default protection for Bear Stearns via the CDS sector suddenly surged. Some investors argued that this simply reflected tangible, rational investor concerns; but some of the Bear Stearns management insisted that rivals were spreading rumours to destabilize the bank, and manipulating thin, murky markets. Whatever the truth, as confidence in Bear crumbled, banks, hedge funds, and investors became extremely fearful about counterparty risk for any contracts where Bear was a counterparty—and rushed to sell them on, or mitigate those risks in other ways. Those moves further fuelled the sense of alarm about the way that CDS was exacerbating systemic risk.

In the event, much of this concern appeared to be ill-founded, since JPMorgan Chase stepped in to rescue Bear, with government backing. A crunch was thus averted. Nonetheless, the events left regulators on both sides of the Atlantic convinced that they urgently needed to reform the way that the CDS market operated and to put it on more robust and transparent footing. So, in the weeks after the implosion of Bear Stearns, the New Federal Reserve and British FSA held a series of meetings with bankers, at (p. 13) which they exhorted the industry to start using centralized clearing platforms, develop more standardized systems for reporting and pricing, and to provide more transparent reporting of deals. Some voices in the industry appeared reluctant to embrace that. Senior officials at ISDA, for example, had previously been very wary of imposing a centralized clearing platform on the industry, and at the body's annual conference in Vienna in the summer of 2008, ISDA made it clear that it was extremely reluctant to embrace more scrutiny or regulation, but as the pressure mounted, ISDA was forced to modify its stance. And by the late summer efforts were accelerating to launch a clearing house—albeit one partly controlled by the sell-side banks themselves.

Controversy about CDS then exploded further in the autumn of 2008. One trigger was the collapse of Lehman Brothers in mid-September. In the days leading up to the failure of the broker, the CDS spread on Lehman—like that of Bear Stearns six months before—swung dramatically. That exacerbated the sense of market unease, and prompted allegations about market manipulation. Then, when the US Fed decided to let Lehman Brothers collapse, concern about counterparty risk resurfaced again, in relation to the numerous deals which Lehman Brothers had written with other banks. In a frantic effort to contain that systemic risk, the New York Fed called all senior CDS traders on Wall Street into its office on the Sunday afternoon, just before it announced Lehman Brothers' collapse, and urged them to cancel offsetting deals. However, that initiative was a failure: the web of deals that linked the banks to Lehman (and each other) proved to be so complex and opaque it was hard to match up the offsetting trades in a hurry, without the presence of a central party, such as a clearing house.

That prompted concerns, once again, about the systemic risk created by the opacity of the CDS contracts. There was also widespread fear about the potential impact of unwinding CDS contracts in which Lehman Brothers was a reference entity: in the days after the collapse of the broker, rumours circulated around the market that banks and hedge funds would need to find around $400bn of cash—or Lehman bonds—to actually honour these deals. In reality many of those fears later proved to be false. In the weeks that followed Lehman's collapse, most of the broker's counterparties managed to unwind contracts which they had concluded with Lehman Brothers without too much difficulty. That was largely because the shock of the Bear Stearns event had already prompted senior managers of banks to debate the issues and to improve their collateral practices. Meanwhile, it also proved far easier to settle deals written on Lehman's credit that had been feared. In the year before the Lehman failure, ISDA had introduced an auction mechanism to settle the price at which a CDS contract should be settled after default, and to allow banks to net off their exposures, without needing to find bonds. In the weeks after the Lehman collapse this system was used, with good results, and the total volume of money that changed hands to settle the CDS was a minute fraction of the gross notional value of all contracts using Lehman as a reference entity.

But even if those events helped to ease some of the systemic concerns, in the days after the Lehman collapse another event crystallized the sense of controversy: the Fed announced that AIG, the insurance group, was all but bankrupt, and it announced (p. 14) a massive rescue package, which initially totalled some $85bn, but later swelled well above $100bn. Once again, credit derivatives appeared to have played a role in this debacle. Most notably, a key reason for AIG's problems was that since the late 1990s, AIG Financial Products had been quietly acquiring the super-senior tranches of CDOs, or writing protection for CDO tranches held by other institutions, using credit derivatives. Few observers outside AIGFP were aware of the size of this activity, but by 2007, the outstanding value of these trades had swelled above $450bn. These left AIGFP exposed to a deadly concentration of risks, which the insurance group had not reserved against, since it was not required to post much capital against these trades, under its regulatory regime. Worse still, many of these CDS contracts stipulated that AIG needed to post more collateral with its counterparties if its credit rating deteriorated. Thus, when credit quality deteriorated in the autumn of 2008 and AIG's own rating was slashed, the insurance group suddenly found itself facing a black hole—for which it was utterly unprepared.

As that news trickled out, in the weeks after the AIG debacle, it unleashed a new wave of criticism of credit derivatives. Some bankers involved in the industry insisted that this was unfair, since the ‘super-senior’ instruments that AIG held on its balance sheet were so specialized that they did not really meet the classic definition of ‘credit derivatives’. This hair-splitting did not convince regulators or politicians: in the aftermath of the AIG collapse, pressure intensified for a thoroughgoing overhaul of the credit derivatives world, to make it radically more transparent, standardized, and robust. There was also a drive to prevent the use of the regulatory arbitrage practices which had been widespread before 2007, and which AIG's business exemplified to a particularly startling degree. For while few regulators believed that credit derivatives per se had actually created the bubble, many were convinced that these instruments had exacerbated the excesses—while the sheer opacity of the sector had made it harder to see the risk concentrations and price distortions. The interconnectivity created by the contracts had also intensified the sense of panic, as groups such as AIG or Lehman ailed. Thus, by late 2008, there was a widespread consensus among Western governments that the credit derivatives market had to change.

By late 2009, these pressures had left the credit derivatives sector at a crossroads. During the course of 2009, a wave of potentially significant changes occurred: efforts got underway to create half a dozen new clearing houses in Europe and the US, to clear a wide range of CDS trades; the level of transparency rose, as groups such as Markit and Bloomberg began to publish prices and the Depository Trust and Clearing Corporation started to publish information about trading volumes and outstanding contracts. Regulators also began to use DTCC figures to create more detailed pictures of counterparty exposures (albeit not for public consumption). Meanwhile, the banks embarked on a big ISDA-lead initiative to tear up offsetting, redundant contracts, with a view to streamlining their exposures. That slashed the gross nominal value of the sector by half, from $62,000bn at the end of 2007, to nearer $31,000bn in 2009. Standardized coupons were also introduced in the US, and industry participants expressed a hope that they would be soon introduced in Europe too. The ISDA-led settlement (p. 15) procedure that was used—so successfully—to deal with the CDS contracts linked to Lehman, in the autumn of 2008, was used for almost two dozen other bankruptcy cases, with smooth results. Last but not least, regulators on both sides of the Atlantic started a crackdown on insider trading in the market, in an effort to dispel long-running rumours that some unscrupulous players were manipulating prices, due to the sector's opacity.

Nevertheless, by late 2009, even amid this plethora of change, some fundamental questions about the sector's future remained. Some American and European politicians remained unconvinced by the scope of the changes, and continued to press for more radical action, such as mandatory efforts to force all activity onto exchanges, or to place the sector under the control of insurance regulators. Some insurance regulators also called for a ban on so-called ‘naked shorting’ (i.e. buying protection without owning the underlying credit), and a few politicians even called for an outright closure of the sector, as a whole. These demands to curb ‘naked shorting’ were further fuelled by allegations that the presence of credit derivatives contracts had complicated efforts to restructure troubled companies after the credit bubble burst. These were rejected by groups such as ISDA, but by 2009, some bankers and lawyers claimed that creditors who had managed to hedge their exposure to a troubled company, or even take net short positions, had no incentive to place a cooperative role in any corporate restructuring, making the process more costly and time consuming.

Such demands for a truly radical clampdown appeared unlikely to gain traction at present, since they were opposed by the US Treasury, European Commission, and most central banks. Inside the largest institutional investors however—and even in the ranks of some sell-side banks—there was a growing acceptance that it might be wise to place at least a few index contracts onto an exchange in the future. Taking that step, some financiers and investors argued, would at least ensure that the industry had a visibly transparent and standardized benchmark—in much the same way that other sectors, such as the equity, foreign exchange, interest rate, or commodities worlds, also had visible, publicly accessible benchmarks that carried wider credibility.

Separately, some central banks remained concerned about the continued opacity in some parts of the market and the threat that CDS contracts could still produce concentrations of risk, rather than dispersion. In August 2009, for example, the European Central Bank released an extensive report on the sector, which pointed out that one of the biggest shortcomings in the market was that non-financial groups had never really adopted the product in any significant manner (in sharp contrast to the situation in, say, commodity, foreign exchange or interest rate derivatives). As a result, the ECB pointed out, most trading in the market continued to take place among a limited number of counterparties, such as banks and hedge funds—and that group had shrunk during 2008, because so many hedge funds (and some banks) had exited the market. As a result, by 2008, data from the OCC data suggested that JPMorgan Chase accounted for around a third of CDS activity in the US market—comparable to the position it held in the late 1990s, when the market was dramatically smaller. Moreover, since many outstanding CDS deals were written on large financial institutions, this was further (p. 16) fuelling a sense of circularity in the market, as a small pool of counterparties offered protection to each other in relation to financial credits.

Nevertheless, these potential shortcomings did not appear to deter market participants. By late 2009, most banks recognized that it was unlikely that the most complex products—such as single-tranche CDOs—would return soon, but they insisted that overall demand for credit derivatives remained strong, at least in their simpler form. That was partly because the events of 2008 had raised concerns about credit risk, not just in relation to companies, but sovereign entities too. Indeed, during the course of 2009, one notable new trend in the market was a rising level of demand for so-called sovereign CDS, both in relation to emerging market debt, but also that of the developed world. That trend threatened to raise the level of regulatory scrutiny of the sector even higher, particularly when spreads started to rise in late 2009; however, it also promised to provide a whole new engine of growth for the CDS world as a whole.

So by late 2009, some fifteen years after the CDS market first sprung to life, the world of credit derivatives essentially looked like the financial equivalent of a teenager: gangly, and a touch unruly, it had grown at stunning speed, producing its fair share of accidents, which had repeatedly dashed the hopes of those who had first created this product; but in the wake of the banking crisis, the CDS world was finally—albeit belatedly—being forced to ‘grow up’ into a more mature, reliable player. Just how long that would take remained critically unclear; so too did the most central question of all, namely whether the CDS market would ultimately end up being able to truly disperse credit risk in a beneficial and rational manner, as a force for good—as its original creators first hoped, before their dreams were so rudely shaken.