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Value of CDS contracts down 85% since financial crisis, BIS says

The notional value of outstanding credit default swap contracts fell 84.6% in the decade following the financial crisis to $9.4 trillion as regulators worked to reduce systemic risk by promoting the role of central clearing houses, according to the Bank for International Settlements.

The nominal value of the swaps contracts had risen tenfold in the years up to the end of 2007, when it peaked at $61.2 trillion. It was then that their role in the near-collapse of American International Group Inc., which had issued hundreds of billions of dollars worth of CDS against AAA-rated securities, many backed by sub-prime loans, brought them notoriety.

Since the crisis regulators have sought to minimize the possibility of any repeat of such a situation, in which very large sums of derivatives contracts could be in danger of being failed to be honored. With most over-the-counter derivatives trades now processed by centralized clearing houses, rather than bought on an inter-dealer basis, there has been a surge in CDS compression, the BIS said in its quarterly review.

Compression is the process of reducing the number of contracts and their notional amount, while maintaining their net liability, by two counterparties agreeing to replace numerous old contracts with fewer new ones.

Outstanding inter-dealer positions fell to $2.3 trillion by the end of 2017, or just 25% of the CDS market, down from $17.7 trillion, or 57%, in mid-2011, the BIS said.

The share of centrally cleared swaps reached 55% at the end of last year, up from 17% in mid-2011. The trade is concentrated among a small number of majors, with euro-denominated contracts largely split between ICE Clear Europe and ICE Clear Credit, which is also the dominant player in the dollar market.

"One of the main sources of risk in the CDS market is counterparty risk generated by the default of large protection sellers. The use of central counterparties has been seen as a way of mitigating counterparty risk and preventing default contagion," the BIS wrote.

The creditworthiness of the swaps has also improved, with investors shifting focus away from bets on junk bonds. "The share of outstanding notional amounts with investment grade underlying credits increased from 42% at end-2007 to 64% at end-2017," the BIS said.