Credit Default Swaps (CDS) were part of the cocktail of exotic financial instruments, which got a lot of attention in the aftermath of the collapse of US investment bank Lehman Brothers. Deutsche Bank Research has published a report which examines the goal of establishing a more stable system for these important products.

DBR says the use of CDSs has become increasingly popular over time. Between 2002 and 2007, gross notional amounts outstanding grew from below $2 trillion to nearly $60 trillion - - about four times annual US gross domestic product (GDP).

The report says a (single name) CDS allows the contracting partners to trade or hedge the risk that an underlying entity defaults - - either a corporate or a sovereign borrower. There are two sides entering into the contract: The protection buyer pays a yearly premium until a pre-defined credit event occurs or until the contract matures. In return, the protection seller assumes the financial loss in case the underlying security defaults or the reference borrower becomes insolvent. In effect, a CDS contract resembles an insurance policy, where one side assumes the risk and the other pays an (insurance) premium.

In the news this week, is a report by Bloomberg News that the Federal Reserve Bank of New York in 2008, then led by current US Treasury Secretary Timothy Geithner, told American International Group (AIG) to withhold details from the public about the bailed-out insurer’s payments to banks during the depths of the financial crisis, e-mails between the company and its regulator show.

AIG said in a draft of a regulatory filing that the insurer paid banks, which included Goldman Sachs Group Inc. and Société Générale SA, 100 cents on the dollar for credit-default swaps they bought from the firm. The New York Fed crossed out the reference, according to the e-mails, and AIG excluded the language when the filing was made public on Dec. 24, 2008. The e-mails were obtained by Representative Darrell Issa, ranking member of the House Oversight and Government Reform Committee.

On Thursday, the FT reported that Morgan Stanley has ended a confrontation with a Chinese company over disputed hedging contracts in an out-of-court settlement that may be a model for ending similar disputes involving mainland enterprises.

The Chinese company was counter-suing Morgan Stanley for allegedly mis-selling the derivative contracts

The Deutsche Bank Research report says that the experience gathered during the crisis significantly contributed to a better understanding of the market for credit default swaps. On the one hand, it became clear that notional volumes outstanding greatly exaggerated credit risk borne by the financial sector as a whole. On the other hand, systemic risk due to the feedback between credit and counterparty risk to a large extent seem to have escaped the attention of risk managers and supervisors alike. The report says the lessons learned from the crisis now open up the opportunity of averting the previous pitfalls and establishing a more stable system going forward.

Against this backdrop, industry initiatives go hand in hand with regulatory proposals in their goals of promoting market infrastructure and reduce systemic risk. CDS markets are now moving from a decentralized towards a more centralized structure, as more and more contracts go through trade compression cycles and become centrally cleared. The widespread use of central counterparties and trade repositories is expected to enhance market transparency. Market participants are left with lower exposures vis-à-vis their respective counterparties, overall gross volume outstanding is reduced, and both private and public sector institutions are gaining better insights into exposures outstanding, leaving the market more robust for withstanding potential future shocks.