Wall Street backs away from credit default swaps

NEW YORK: Trading in credit-default swaps, Wall Street’s fastest-growing business before the credit crisis, has tumbled 40-60 % from three years ago as banks prepare for new regulation of derivatives.

The declines estimated by executives at four of the biggest dealers of swaps means lower profits at firms that used to get as much as two-thirds of credit-market trading revenue from the derivatives. Moody’s Investors Service says pending rules may translate into job cuts of as much as 50% in groups that trade the contracts.

Investors are avoiding strategies that contributed to $1.82 trillion in writedowns and losses amid the worst financial crisis since the Great Depression. The net amount of credit swaps outstanding globally has fallen 20% from October 2008, the earliest figures disclosed by the Depository Trust & Clearing Corp in New York.

“This was a major profit centre for a lot of banks,” said Hal Scott, a Harvard Law School professor, who also is a director of the Committee on Capital Market Regulation , a non-partisan group of academics and business executives that in May 2009 called for measures to reduce the risks derivatives pose. “It’s part of a bigger picture of reduced financial activity due to uncertainty and regulatory reform.”


While JP Morgan Chase & Co created credit swaps in the 1990s as a way for investors to protect themselves against loans going bad, trading soared after the industry began developing standard terms by 2003.

The contracts, in which a seller of protection is paid an annual premium for agreeing to cover the buyer’s losses should the underlying borrower default, ballooned to more than $62 trillion at the peak in 2007 on a gross notional amount from $632 billion in 2001.

In October 2008, Richard Fuld, then chief executive officer of Lehman Brothers Holdings, blamed his firm’s collapse partly on “destabilizing” forces including the escalating cost of swaps on the investment bank’s debt. Hedge fund manager George Soros called the market “unsafe”, and billionaire investor Warren Buffett once likened derivatives to “financial weapons of mass destruction” .

Unlike with Treasuries and corporate bonds, dealers don’t disclose historical trading volumes in swaps. The four banks provided estimates on the condition they not be named. Derivatives are contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

The five biggest dealers — JP Morgan, Goldman Sachs Group Inc, Morgan Stanley, Citigroup Inc and Bank of America Corp — bought a net $430 billion of credit protection as of September 30, down 38% from $689.9 billion in March 2009, filings with the Federal Reserve Bank of New York show.

Barclays Plc analyst Roger Freeman in New York estimates that before and during the credit crisis, Goldman Sachs generated two-thirds of its credit-trading revenue from derivatives. The contracts now likely contribute about a third, with the rest coming from bonds, he said. Michael DuVally, a spokesman at Goldman Sachs in New York, declined to comment.

Average daily trading in US corporate bonds fell 12 per cent the past six months compared with a year earlier, according to the Securities Industry & Financial Markets Association, a trade group.

While Freeman expects a rebound once regulators meet their July deadline to write market rules, the changes will likely squeeze profit margins and prompt bank executives to cut more trading jobs.