Credit Derivatives Market Shrinks 12%, First Decline

Credit-default swap dealers reduced outstanding contracts for the first time amid efforts to cut risk by cleaning up the derivatives market.

The volume of trades in the worldwide market fell to $54.6 trillion from $62 trillion in the first half, the International Swaps and Derivatives Association said in a statement yesterday. It was the first decline since New York-based ISDA started surveying traders seven years ago.

Credit-default swaps grew 100-fold since 2001 as insurance companies, hedge funds and investors used the derivatives to protect against bond losses and speculate on companies' abilities to pay their debt. Traders are unwinding trades and protecting against losses after credit markets froze amid the worst U.S. housing crisis since the Great Depression. Regulators are starting to call for more oversight of the unregulated market following the bankruptcy last week of Lehman Brothers Holdings Inc.

``I would expect that if they were to re-poll next week, you would see an even smaller number from netting activities and trade cancellations surrounding the Lehman Brothers default,'' said Brian Yelvington, a strategist at CreditSights Inc. in New York.

ISDA's survey covered trading as of June 30. The so-called notional value in the report measures the gross U.S. dollar amount of debt protected, not the net risk from trades. Credit- default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should the borrower fail to adhere to its debt agreements.

U.S., Europe Bond Risk

Benchmark credit-default swap indexes fell today, a sign that investor perceptions of corporate credit risk improved. Contracts on the Markit CDX North America Investment Grade Index of 125 companies in the U.S. and Canada fell 4 basis points to 165 basis points as of 9:22 a.m. in New York, according to broker Phoenix Partners Group. The Markit iTraxx Europe index of 125 companies with investment-grade ratings fell 0.5 basis point to 116, JPMorgan Chase & Co. prices show.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

After the collapse in March of Bear Stearns Cos., 17 banks that handle about 90 percent of trading in credit derivatives agreed to initiatives to curb market risks, at the behest of the Federal Reserve Bank of New York. The changes included tearing up trades that offset each other to help reduce day-to-day payments, bank staff paperwork and potential for error. The tear-ups may also reduce the amount of capital commercial banks are required to hold against the trades on their books.

Cutting Contracts

TriOptima AB, a Stockholm-based company formed to help banks cancel outstanding derivatives, said it cut $17.4 trillion in credit swap contracts during the first half.

Data provider Markit Group Ltd. and broker Creditex Group Inc., which were hired by dealers in July to complete the tear-up initiative in the Fed-instigated plan, said in August that 14 dealers reduced contracts submitted on North American telecommunications companies by 56 percent. During a second stage finished three weeks ago, 15 dealers cut contracts on European telecommunications companies by 53 percent, the companies said.

Declining open interest ``primarily reflects the industry's efforts to reduce risk by tearing up economically offsetting transactions and demonstrates the industry's ongoing commitment to reduce risk and enhance operational efficiency,'' ISDA Chief Executive Officer Robert Pickel said in the statement. ``We expect to see more effects of this over time.''

The initiative also comes as state and federal authorities seek regulations on the market for the first time since it was created a decade ago.

`No Rational Basis'

U.S. Securities and Exchange Commission Chairman Christopher Cox on Sept. 23 told the Senate Banking Committee that Congress should ``immediately'' grant authority to regulate the market amid concern that trading is fueling the financial crisis.

New York Governor David Paterson said in a statement on Sept. 22 that the state will start regulating some derivatives by deeming them insurance and requiring sellers to be licensed.

A widening in the difference between the cost of buying and selling protection on credits including Morgan Stanley last week had ``no rational basis,'' and helped drive down his firm's stock price, said CEO John Mack.

Other derivatives markets grew, ISDA said in its statement yesterday. The notional amount of derivatives used to hedge against changes in interest rates increased 22 percent during the first half of 2008 to $464.7 trillion. Contracts linked to equities grew by 19 percent to $11.9 trillion.