Merrill Lynch and J.P. Morgan are leading an initiative to net credit-default swap contracts for the first time to reduce the amount of time traders have to spend settling contracts in the event that the reference asset defaults. "Net settling will be a great thing if we can do it because anything that will increase liquidity is good," according to Anjan Malik, a credit derivatives trader at Lehman Brothers in London. He added that an obstacle could be firms' reluctance to share information on positions with their competitors.
The plans were triggered by the sharp drop in credit derivatives business that followed Railtrack's recent default, as dealers turned their attention to the administrative tasks associated with settling trades (DW, 10/21). Officials at Merrill and J.P. Morgan said they hope the system is operational in time for the next large-scale credit event, which is likely to be a default by either Argentina or Marconi. "The plan is to line up the contracts in tripartite agreements," said Neil Walker, head of credit derivatives trading at Merrill in London. "It would grow into an overall clearing system but we're probably a little away from that," he added.
In light of the Railtrack case, the first major credit event in the European market, Merrill and other firms are discussing which reference credits they are prepared to net in the case of future defaults. "It's only really worth it if there's more than 10 or 15 contracts per bank," said one trader. He estimated there are approximately 50 European credits that would qualify. Those contracts that could not be offset through the system would then be settled by the normal administrative process. For example, firms would sign bilateral or trilateral agreements and pay accrued interest on the contracts' premiums after a credit event. "To the extent that you can build a loop between a few dealers, you don't have to go through the settlement process," said Guy America, head of European credit derivatives trading at J.P. Morgan in London.
