There is a lot of talk about the +$60 trillion notional outstanding CDS (credit default swaps).
There are a few types of risk associated with CDS, but the most esoteric and least well understood is systemic failure due to settlement failure cascade and or related counterparty seizure. Basically this occurs when one party can't make good in the short term during a default event and other market participant halt outgoing payments. This is topical as the Freddy & Fannie defaults are a large default event.
The interesting thing about systemic OTC settlement risk is that it is actually increased due to the offsetting of risk individually. It is a case of the tragedy of the commons, the commons in this instance is systemic integrity and faith in counterparties ability to interact, the interbank financial system if you will.
A grossly simplified example will explain it. Party A wishes to place a bet on Frannie default risk by purchasing CDS protection on Frannie. Party A buys protection from B. B is now exposed to the risk of a Frannie default and decides to hedge this risk by buying Frannie CDS protection from party C. C holds the position with net exposure for awhile, gets nervous and then offsets by purchasing protection from Party D, who then offsets the exposure with Party E.
For the sake of simplicity we will assume the default event of Frannie requires $10m in cash or securities to be delivered within 5 business days of the acknowledged default event. Now all of the parties involved have done their risk assessments of their downstream counterparty using various estimates of the counterparties credit quality and liquidity. They have each come to the conclusion, that their next counterparty has a .001% chance of failure at any point in time. They could thus assess the counterparty risk exposure in crude nominal terms as being $10mx 0.01% = $1,000. This feels safe.
Looking individually each party assumes they have $1,000 in risk. In reality A faces $4,000 in probable risk. The chain is only as strong as it weakest link. The end settlement party A has $4,000 exposure (1-(1-.0001)^4)*$1,000. Party B has a $3,000 exposure etc. The longer the chain the greater the systemic risk for the initiator and the potential for a failure to deliver on time etc.
There are currently various initiatives to "compress" the risk by netting out the exposure via centralized clearing by the bigger parties. Another risk associated with CDS is that a party in the chain may dispute what determines an EOD and hold up payment until resolution. Fortunately with the Fannie and Freddy situation 13 major banks have agreed to declare a default. What is unknown is the length of the chains and notional amounts outstanding relative to available liquidity. Settlement failure due to liquidity is known as Herstatt risk.
Let's hope the CDS interbank settlement "system" passes the "buck" around in a timely fashion. It should be noted that a single break in the chain won't necessarily cascade through the chain as each bank should have excess liquidity as a buffer.
A single failure does drain a single bank and system liquidity (due to fear) and cause counterparties to typically suspend settlements. This occurred when Barings went down. Before the Bank of England stepped in there was $22b in settlements held up by groups exposed to Barings and not wanting to settle trades for fear of not getting the counterpart of the transaction,(yen/swiss franc for example). This was caused by a $2b problem and could have cascaded out not from just Barings but a cascading ring of those know to have Baring exposure in the 1st, 2nd or 3rd degree of separation etc.
The simple model above is illustrative more than demonstrative. That being said, liquidity is tight these days and fear made many banks offset risk thus growing the chains recently. Local risk reduction behavior of offsetting positions and exposures may actually have increased system settlement exposure. Keep your fingers crossed as writing extreme out of the money options contracts like CDS is a bit like putting out Black Swan food. Banking and money are social institutions built on faith, they don't adhere to the laws of physics. It is important to remember that all social institutions ebb and flow over time.
