Deutsche Bank and other investment banks are evidently considering plans to develop a clearing house for credit default swap trades. The $62 trillion market (up from less than $2 trillion in 2002) has given rise to substantial fears of “counterparty risk,” particularly in the wake of the near bankruptcy of Bear Stearns. Because these trades are unregulated, there is no way of knowing at this time how many, and to what extent, banks, funds, and other investors are going to be exposed to CDS payment demands. Of equal concern are the exposures of the CDS buyers who believe themselves to be properly hedged against specified losses (not the least of which, for many large institutions, are their positions as CDS sellers that they prudently sought to match), but who may instead find their protection to be worthless because of their counterparty’s inability to pay.
Given both the immense size of the CDS market and how poorly risk in other asset classes was assessed and priced over the past several years, CDS counterparty risk is accurately being called the “sword of Damocles” hanging over the financial services industry. The term “counterparty risk” will likely soon move alongside “subprime borrower” as a disquieting addition to the financial lexicon.