Credit Default Swaps: The Risk of Inefficient Markets Executive Summary                                                     The credit crisis has injected volatility and additional market risk to the CDS market; however, it is operational risk that has taken center stage.  CDS trading grew so quickly that computer systems and operations teams could not keep up with the volumes coming out of the trading desk, creating errors and leaving many trades unconfirmed. Even today, with nearly 90% of CDS

With technology at the forefront to solve many of these problems, the burden now lies with the market participants.  Technology and operations teams have long been relied upon to sort out processing issues, while leaving the front office to trade.  This separation of responsibility is finally evaporating, however, as the risk is far too great.  If incorrect trade details cause a monetary loss, or the given counterparty defaults on a payment, it is not the operations team that sees a hit to their bottom line, but the trader.

Matching of trade details on day one is still a rarity.  Even when trade details are confirmed via email or phone on T+0, subtle trade entry errors are not detected until exception reports are received from the confirmation utility in the following days.  This delay creates a large time chasm in which millions of dollars in notional value are left unconfirmed.  The nearly $2 trillion in notional value novated per firm in 2008 creates an even bigger risk, as three counterparties must agree on the details of the transaction before it can be made official.

With the knowledge gained from past derivatives debacles and state-of-the-art technology already in existence to solve these problems, there is little reason for the credit derivatives market to endure such risks.  An affirmation solution to handle both new trades and novations via an expansive network of the world’s largest CDS dealers and investors can provide both increased efficiency and reduced risk while still supporting the OTC model.  This approach will leave the confirmation utilities to focus on confirmations, leaving traders – not operations or a third party - to ensure that trade details exist as intended.

The TABB Group Report on Credit Default Swaps:
The Risk of Inefficient Markets

This report is based on conversations with Credit Default Market participants including bulge bracket broker-dealers, solutions providers and industry-wide utilities.  Front office staff and technologists all presented unique views of the state of the Credit Default Swap market.  The report outlines the importance of injecting further automation into the processing of Credit Default Swaps as a key method of reducing market and operational risk in conjunction with the critical elements of a successful industry-wide solution.