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From the second half of the 1990s onwards, credit derivatives and insurance products have been commonly used by market participants to manage and transfer credit risk associated with financial instruments such as structured finance and traditional debt instruments including loans and bonds. Credit derivatives have been popular but their unregulated nature has been blamed for playing a role in the bankruptcy filing of Lehman Brothers, the federal rescue of American International Group as well as the downturn of the stock markets during the global financial crisis. While there may be uncertainty in the future of credit derivatives due to regulation and standardization, financial institutions have been creating alternative financial instruments to manage and transfer their credit risk, and financial guarantees are one of the hot topics in the current market.
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The credit derivatives market underwent major reform in 2009 and more reform is yet to come. The market has certainly been moved by the changes already implemented, with CDS clearing (possible, amongst other things, as a result of the fungibility created by the dynamic protection period introduced by the Big Bang) now taking hold. Of course, many challenges for the market still remain and many politicians still retain their (often ill-informed) opposition to the use of credit derivatives. But the rapid, industry driven, reform in 2009 has rightly been recognised as a step in the right direction.
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On the day when KfW wired EUR300 million to the defaulted Lehman Brothers, it became clear that a new regime for risk control and counterparty risk assessment was imminent. No longer could the middle office operate in an end-of-day or end-of-week environment while the front office operated in real-time. This article illustrates how an institution can significantly enhance its ability to actively manage counterparty credit exposure by using credit default swap information provided by the Credit Market Analysis (CMA) independent CDS data service. It will also introduce CMAs market activity indicators, which provide information that is not contained in CDS pricing, but which can have a significant and valuable impact on counterparty credit assessment.
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A number of significant changes are under way with respect to the credit default swaps market. Market participants will need to grapple with the shift away from familiar bilateral relationships and industry standard documentation to each clearinghouse's own rules and procedures.
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A recent decision in the U.S. Lehman Brothers bankruptcy case held that investors in a collateralized debt obligation called Dante did not have the right to jump ahead of Lehman to get repaid, contradicting an English court decision and raising questions about how similar deals will be treated.
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The credit crunch has focused a lot of attention on bank capital ratios. With recent large write-downs in asset values, the implementation of Basel II's risk based capital requirements and the possible introduction of further changes following the Basel Committee's December consultation paper, banks face the prospect of holding increasing levels of regulatory capital as the assets they own deteriorate in both credit and rating quality.
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The dispute resolution mechanism established as part of the Big Bang Protocol was recently put to the test for the first time in connection with Cemex.
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On Oct. 20, the European Commission published a document titled: "Ensuring efficient, safe and sound derivatives markets: future policy actions."
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Counterparty credit risk management has been evolving for over a decade from passive risk quantification and reserves to active management and hedging.
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This Learning Curve examines why central counterparties might consider permitting issuers of bonds to write credit default swaps on themselves.