CDS counterparty risks serious threat to global financial markets

Over 75% of institutions said counterparty risk in credit default swaps (CDSs) represents a serious threat to global financial markets, according to a study by Greenwich Associated.

Greenwich Associates conducted a study of 146 institutions in North America and Europe to determine how fears of counterparty risk were affecting institutional investment and trading strategies.

The study revealed that 37% of participating institutions have over $50 billion in assets under management. A further 18% have more than $100 billion.

Survey respondents were divided between 32 hedge funds, 114 banks and traditional long-only investors, with the majority domiciled in the US (70%) and 30% in Canada and Europe.

Among US institutions, 85% sees credit default swap (CDS) counterparty risk as a serious threat to global markets. Institutions in Europe are slightly more sanguine; with just over 55% describing CDS counterparty risk as a significant danger.

Over 905 of hedge funds, however, said they see counterparty risk relative to credit default swaps as posing a significant threat to global markets.

Most of the institutions surveyed believed another major financial services company collapse is likely. Almost 60% said they expect to see another major collapse within the next six months. A further 15% think it will happen in six to 12 months. Less than a third (27%) of institutions believe there will not be another casualty along the lines of Bear Stearns.

Almost 80% of survey respondents said their banks had tightened margin or collateral requirements since the global credit crunch. The survey results indicated many of the banks widely viewed as being hit hardest by the credit crisis have been the most aggressive in tightening the margin and collateral requirements imposed on trading clients. Even banks that emerged relatively unscathed have tightened terms, according to the survey.

A majority (nearly 65%) of institutions that say banks have imposed stricter requirements said the change has not had a significant impact on their trading activities. Over a quarter said new requirements caused them to reduce trading activity.

Counterparty risk concerns have caused institutions to cut back on their use of CDSs. Of fixed-income survey participants that use CDS, 62% said increased counterparty risk has caused them to limit their use.

Over 70% of all participating institutions said the most common way of managing counterparty risk was to trade only with the most financially sound banks and broker dealers. Almost 65% of participants said they try to limit the concentration of exposure with a single counterparty. About one-third said they use cross-collateral arrangements and 5% said they use exchange products for hedging.

Institutions in general support efforts to reduce counterparty risk in the credit default swap market by using a centralised clearing entity. Three quarters of said they believed setting up such an entity would be effective in mitigating CDS counterparty risk.

Hedge funds and institutions in continental Europe were among the strongest proponents of this plan. Almost 85% said it would help reduce counterparty risk. Almost 60% said they would prefer a centralised clearing platform operated by an exchange over one sponsored by banks.

Seven out of 10 hedge funds said they would rather use a clearing entity operated by an exchange than one operated by the banks.