The Problem

The Problem

Summary: Following a number of unintended consequences by the Pittsburgh Reform of financial derivatives (2009-2016) the CDS market has collapsed as trust in contract execution has evaporated.

Credit default swaps (CDS) are a type of insurance against default risk by a particular government or private entity. The entity is referred to as  a “reference entity” and the default  as a “credit event”. It is a contract between two parties, a ” protection buyer” and a “protection seller”. Under the contract, the protection buyer is compensated for any loss emanating from a credit event in a reference instrument. In return, the protection buyer makes periodic payments to the protection seller.

After the Financial Crisis of 2007-8 the G-20 governments undertook a major regulatory reshuffle of the derivative markets. One of the modifications introduced was to mandate loss sharing between derivative holders and financial institutions in case of  a systemic event.

This was introduced in the EU by Directive 2014/59/EU art.44, 49 and related (effective since 2016) and in the US by the Dodd-Frank Act Section 165(d) and related (effective since 2014). All other G-20 governments introduced similar rules between 2012 and 2016[1].

Moving derivative holders from first to fifth place in a resolution has created a climate of uncertainty that the obligations taken by financial institutions to pay defaulted credit will be met, as credit events are most concentrated during systemic events and its financial turbulence.

[1] http://www.fsb.org/2016/08/otc-derivatives-market-reforms-eleventh-progress-report-on-implementation/

The current model of the CDS contract is based on extremely low reserves (typically less than 0.1%) that are syndicated in collateral pools that are posted in a syndicated manner. This is what we aim to change and individualize the posted collateral by the protection seller…. Read more

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