Counterparty risk growing threat to global market, says study

Investors are turning away from credit default swaps for fear of counterparty risk

STAMFORD, CT – Counterparty risk from credit default swaps (CDS) is seen as a serious threat to global financial markets, according to three quarters of institutions participating in new research by Greenwich Associates.

In the wake of the near collapse of Bear Stearns and its Fed-engineered buyout by rival JP Morgan, the study revealed almost 60% of respondents thought another large financial services firm would collapse within the next six months, and a further 15% within the next 12 months.

The survey relied on North American and European financial institutions, and found that more sophisticated investors were slightly more optimistic than other investors, but the overall picture was still pessimistic.

Greenwich Associates consultant Frank Feenstra says: “Only 27% of the institutions think there will not be another casualty along the lines of Bear Stearns. If you are looking for a silver lining in these findings, it seems that most institutions think we are currently in the most dangerous period for global financial services firms. Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside.”

Firms have also turned away from CDS, with 62% of fixed-income survey participants that employ the swaps saying increased counterparty risk has caused them to reduce their use.

Almost 80% of participants said their banks have tightened margin or collateral requirements since the outbreak of the global credit crunch, especially those hit hardest by illiquidity and writedowns of bad subprime debt. Over a quarter of institutions said their trading activities had been lessened by the market austerity.

Concerns about counterparty risk have caused institutions to cut back on their use of CDS. Among fixed-income survey participants that employ CDS, 62% say increased counterparty risk has caused them to limit their use. For 70% of respondents, their main way of reducing counterparty risk was to trade only with the banks and broker dealers considered most financially sound.

There were also strong indications of support for centralised clearing systems for CDS, especially strong from hedge funds and continental European institutions. In particular, seven out of 10 hedge funds said they would rather use a clearing entity operated by an exchange than one operated by banks.

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