Derivatives

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  • Topic: Credit default swap, Credit derivative, Credit risk
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WP/09/254

Credit Derivatives: Systemic Risks and Policy Options
John Kiff, Jennifer Elliott, Elias Kazarian, Jodi Scarlata, and Carolyne Spackman

© 2009 International Monetary Fund

WP/09/254

IMF Working Paper Credit Derivatives: Systemic Risks and Policy Options? 1 Prepared by John Kiff, Jennifer Elliott, Elias Kazarian, Jodi Scarlata, and Carolyne Spackman Authorized for distribution by Karl Habermeier November 2009 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Credit derivative markets are largely unregulated, but calls are increasingly being made for changes to this “hands off” stance, amidst concerns that they helped to fuel the current financial crisis, or that they could be a cause of the next one. The purpose of this paper is to address two basic questions: (i) do credit derivative markets increase systemic risk; and (ii) should they be regulated more closely, and if so, how and to what extent? The paper begins with a basic description of credit derivative markets and recent events, followed by an assessment of their recent association with systemic risk. It then reviews and evaluates some of the authorities’ proposed initiatives, and discusses some alternative directions that could be taken. JEL Classification Numbers: Keywords: Financial Derivatives, Financial Stability Author’s E-Mail Address: jkiff@imf.org, jelliott@imf.org, ekazarian@imf.org, and jscarlata@imf.org.

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This paper benefited greatly from comments from Jochen Andritzky, Charles Blitzer, Randall Dodd, Karl Habermeier, Matthew Jones, Laura Kodres, and Manmohan Singh.

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Contents

Page

I. Introduction ............................................................................................................................3 II. Market Structure and Recent Developments.........................................................................3 III. Do Credit Derivative Markets Increase Systemic risk?.......................................................8 A. Operational Risks Remain but are Continuing to Abate Amid Significant Infrastructure Improvements..........................................................................................8 B. Counterparty Risk Exposures Remain a Systemic Concern ...................................15 C. Poor Disclosure and Transparency Standards Leave Authorities in the Dark ........16 D. Lack of Transparency and Market Surveillance Compromises Market Integrity...16 IV. Should CDS markets be regulated more closely?..............................................................17 A. Centralized Clearinghouses Will Reduce Counterparty Risk .................................17 B. Need for Regulatory Coordination..........................................................................22 C. Improving Disclosure of Credit Derivatives Transactions......................................24 D. Improving Disclosure in Financial Reporting of Credit Derivatives......................25 E. Improving Disclosure of Credit Derivatives Transaction Data to Authorities........28 F. Improving Market Integrity and Surveillance .........................................................29 V. Summary and Conclusions..................................................................................................31 Tables 1. Initial CDS Clearinghouse Proposals...................................................................................21 2. Disclosure Improvements of Major CDS Dealers ...............................................................27 Figures 1. Global Credit Derivatives Outstanding..................................................................................4 2. CDS Notional Outstanding:...
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