The CCDS solution

Collateral use has soared among dealers in recent years. In its most recent margin survey, published in April, the International Swaps and Derivatives Association reported that the amount of collateral in circulation has reached $1.335 trillion - a small increase from last year's $1.329 trillion, but light years away from the $250 billion in circulation in 2001. The number of credit support agreements in place has also risen, from 109,733 in 2006 to 133,193.

In another survey released by Isda, the top 10 dealers reported that credit support annex (CSA) coverage of interdealer exposures averages 92% - most, in fact, said all their interdealer exposures were covered by CSAs. Dealers and risk managers can, rightfully, feel pretty pleased with themselves.

But that doesn't quite tell the whole story. Yes, use of collateral, margining and netting has drastically reduced dealers' exposures to one another. But there's a huge volume of business conducted with corporates, hedge funds and asset managers, many of which are reluctant to post margin. Isda reports that just 35% of counterparties outside the interdealer market are covered by CSAs. That represents a significant risk to banks. The question is how to hedge it.

One solution currently being touted is contingent credit default swaps (CCDSs). In essence, CCDSs are similar to traditional credit default swaps (CDSs), except the payout in the event of default is referenced to the mark-to-market of another derivatives transaction - for instance, an interest rate swap. The product is designed to more closely replicate the actual exposure the protection buyer has to the reference entity.

These instruments have been around for some time - although not widely traded - but a handful of dealers are now making a concerted effort to get them off the ground (see pages 28-30). They face a number of difficulties, however. First, the market is likely to be dominated by protection buyers. There has been some interest from investors in selling protection in return for premium, but the market is likely to be largely one-way, with banks looking to hedge the exposures on their books.

Others say there's actually little need for these products, and that the exposures can be hedged using a combination of CDSs and other derivatives. Regardless of whether CCDSs ultimately prove to be the best solution, it's good that banks are looking seriously at counterparty credit risk and are keen to find ways to mitigate their non-dealer exposures.

On a separate note, Risk magazine is coming up to its 20-year anniversary this year. To mark its two decades in the business, we will publish a special anniversary issue next month to coincide with a 20-year party celebration at the Royal Courts of Justice in London on July 10 (see www.risk.net/risk20 for further details).

Nick Sawyer, Editor