This article appeared in Capital page of The Edge Malaysia, Issue 794, Feb 22-28, 2010.

Understanding Credit Default Swaps: Can Malaysia do it

differently?
By Jasvin Josen

In the last three articles, we discovered how the CDS came about to hedge default risk but over time
exploded and brought on the crisis. Now the CDS is undergoing painstaking rehabilitation to become
a safer product in a hopefully more stable system.

Should CDSs be introduced in Malaysia? As I pointed out in the first article, the timing seems
advantageous for we can learn from the market’s earlier blunders. However, deep thought must be
put into outlining the product features and regulation around the CDS for the product to be traded
successfully.

The prospective CDS in Malaysia

The Malaysian Rating Corp Bhd. believes that the CDS should be introduced to spur bond trading.
This may not be the best motivation, as the CDS was primarily created to cover losses in case of a
credit default. In fact, according to data compiled by Fitch in 20061, investment grade and high yield
bond trading experienced declines during the period of the CDS boom. Investors prefer trading CDSs
compared to bonds. The CDS allows speculation by not owning a bond, just like an option on equity.
The CDS is also easier to utilise as it allows cash settlement and enables investors to go short without
having to borrow securities. Moreover, the CDS can be used as an early warning indicator; spread
moves can tell sentiment on the underlying credit. The recent Dubai crisis saw its CDS spreads
jumping in Nov 2009. As such, it is fair to conclude that the CDS will probably not stimulate bond
trading per se.

Source: The Economist Issue of Dec 3, 2009

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Fitch: High Yield CDS Trading In U.S. Names On The Upswing, 28 Sep 2006
However, that it no way indicates that Malaysia should not introduce the CDS, as it will certainly spur
the credit market as a whole. Towards this end, the first step would be to introduce the standard
single name CDS. In time, the standard first-to-default baskets and CDO will naturally follow. Where
possible, these products should share the same features as the global market. An exchange and
clearing house should be in place and all market participants, financial and non-financial must be
included to prevent the motivation to find loopholes.

Allowing naked CDS trading is a delicate subject, but this will have to be allowed or else I do not
believe the CDS market would flourish. In any market, we need speculators to be on the other end to
take the risk, or there will be no liquid market.

As the CDS becomes more bespoke, the OTC market will grow, Bespoke products could be single
name CDSs with step up coupons; with obscure maturity; tied to an option; or with an illiquid
reference asset. It could also be first and nth-to-default baskets or CDOs with bespoke credit names.
We must build adequate boundaries around the OTC market, following the outcome of the OTC
credit market in Europe and the U.S.

Regulation measures

We know that global regulation efforts are experiencing issues and are still being debated, especially
around the bespoke products that were the main cause of the crisis.

Keeping in mind the objectives of regulating the credit financial market will help to draft regulations
more effectively. A recent speech by the Chairman of the U.K. Financial Service Authority (FSA) in
Nov 20092 summed up the three objectives of regulation quite nicely:

Reforms around capital and liquidity to make the banking system a shock absorber rather
than a shock amplifier

Reforms to deal with large systematically important, potentially too-big-to-fail banks

Actions to reduce interconnectedness in OTC derivative markets; migrating as many

contracts to central counterparty clearing systems, ensuring adequate capital and collateral
against remaining bilateral contracts.

Bespoke credit derivatives cannot trade through the exchange but will have to remain as OTC
products. However the counterparties and trades should be disclosed to a separate reporting
channel. Collateral must be posted by the protection seller as a standard procedure. As pointed out
in the last article, the calculation of the margin cannot be based on volatility of historical prices.
However, other methods could be used to calculate margins, for example, taking a certain
percentage of its mark-to-market value.

Transfer of credit risk by commercial banks ought to be reported and the protection sellers known
and monitored. Insurance and Pension funds must be responsible for what sort of protection is sold.
An industry rule that sellers must pose high (say 70%) collateral, regardless its ratings will control

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Speech by Lord Turner, Chairman FSA – British Embassy, Paris, 30 Nov 2009
trading activity from getting out of control. All these may sound harsh - the Glass Steagall Act was
viewed as too harsh but banks adjusted and all worked fine, until the Act was repealed.

The regulators

The regulators themselves must be credible in the public eye, ones who understand credit
derivatives right from trading strategies to how it gets into the books of the counterparties. At the
same time, rating agencies should never be complacent with any structure that might “appear” to be
riskless. They also should use valuation techniques that are in line with the market to avoid major
deviations in risk assessment.

Tackling valuation

Once the CDS has more than one reference asset, valuation becomes a challenge, as it involves
estimation of correlation among defaults. The various modelling techniques available to estimate
default correlation throws out extremely wide range of prices. We recall that other difficult
parameters like counterparty risk and prepayment risk (for loan-based CDOs) were modelled far
from reality as well.

There is still no standard valuation in place globally for the CDO; regulators will have to take a
stance, either to allow the product but with one accepted valuation technique, or not to permit the
product at all. I would advocate the former, as with the appropriate controls that promote
transparency, the market can thrive.

Other considerations

In devising the regulations, the FSA also noted two important considerations besides direct
regulation of the market. Firstly, determining the optimum level of capital ratios is vital. This can be
very judgemental and difficult; too high a ratio will increase the cost of credit intermediation.

Secondly, the level of trading activity should not go beyond its economically efficient size. Three
ways were suggested:

Regulating remuneration – this is an almost impossible job as in the long term. Already
complex schemes are being devised in the UK for top executives to avoid the 50% tax and
the super tax on bonuses above £25,000

Imposing appropriate capital requirements. The previous capital regime for trading activity
based on value-at-risk models was found to be too simplistic and ignored liquidity risk

Taxes on financial transactions - Tobin tax which some (like Paul Krugman, Noble Prize
Winner) believe could have prevented the crisis

Incidentally at the world economic forum in Davos recently, President Obama also proposed to limit
the size of banks and their trading activities.

The repeal of the Glass Steagall act that separated investment and commercial banking activities
may well have contributed to the whole CDS debacle. We hear a calling for a similar version of this
Act now. At the time of writing, President Obama at the Davos forum put forward that deposit-
taking banks would not be allowed to own, invest or sponsor proprietary trading, hedge fund or
private equity business in order to protect the peoples’ money.

It is a concern that in Malaysia, several investment banks have commercial bank arms. Extensive
government guarantees would just add to the moral hazard problem. A bank can operate with high
leverage, safe in the knowledge that it will still be able to borrow and raise deposits cheaply,
because creditors know they are guaranteed.

Conclusion

The CDS market had become somewhat a victim of its own success. The problems started when it
branched off into the highly bespoke and complicated products like the CDO that deviated from the
basic purpose of the market. The bundling of all kinds of loans into securities led to irresponsible
lending. The modelling of the underlying factors was far from reality. Rating agencies also seem to
misunderstand the risks of mortgage-backed securities.

But the future is bright for Malaysia if we could introduce the CDS in the right environment. The goal
of regulation should be steered towards increasing transparency, improving information flow and
enhancing liquidity, rather than restricting the natural evolution of the derivatives market. We
should strike a fine balance between imposing controls while still maintaining a liquid and appealing
market.

At the same time, authorities must continuously keep in step with global developments around
product innovation, valuation and regulation. Local regulators should either adapt or stay abreast
with the Basel Committee who is fundamentally reviewing their trading book capital regime. Finally
one must keep in mind that regulations are never really foolproof; products in a free market
continue to develop to keep the regulators on their toes.