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Despite the huge amount of regulation already aimed at the broader derivatives market, there is concern that it will be insufficient to cover continuing questions that regulators have about its functioning. “The question is will the reform currently under finalisation or implementation, such as EMIR in Europe, be enough? Credit default swaps are derivatives on credit that look like insurance products.“
At the top of the regulators’ list of worries is that CDS are increasingly being used for regulatory purposes in credit value adjustment (CVA) trades. Regulators and dealers alike have noticed a problematic effect of the Basel III CVA charge, by which counterparty risk is calculated on the basis of CDS spreads. Under Basel III, banks are allowed to buy CDS to offset capital requirements. This increase in activity once the capital requirement is introduced in 2013 could, it is feared, distort the CDS market.
“It can create a world where there are lots of natural buyers of CDS. It may encourage banks to buy CDS protection to reduce capital requirements related to their counterparty credit risk [noting that CDS are used in the calculation of the CVA] and these may have an important impact on those markets. It may create some kind of feedback loop. The more CDS you buy to hedge your counterparty risk, the more the CDS increase in value and the more markets become difficult, volatile and possibly overvalued”, Vieillefond said.
Another issue rattling regulators is the jump-to-default risk — the risk of immediate default — inherent in CDS. Jump-to-default risk, argues the AMF, “seriously complicates the management of risk in the CDS market, since the resulting price discontinuity is hard to model and the seller’s collateral requirement may be underestimated, thus intensifying counterparty risk". This characteristic of CDS is something regulators are seeking to address.
Another peculiarity of the CDS market regulators are unhappy with is banks selling protection on their home sovereigns or other credits to which the bank is exposed to counterparty risk. This activity could be another aspect of the CDS market that attracts more rules.