The possible failure of a large player in the credit default swap market remains a systemic risk, says Moody’s Investors Service in a new report.

The rating agency reports that the bankruptcy of Lehman Brothers “put the CDS market to an unprecedented test”, that it has largely survived. Lehman’s failure resulted in losses in the hundreds of millions dollars for a number of Moody’s-rated firms, but these CDS market disruptions have not, in and of themselves, resulted in the downgrade of any company to date, Moody’s said.

Its survey of the major Moody’s-rated banks and insurance firms active in the CDS market suggests that the overall market has fared better than many observers had anticipated. “Lehman’s bankruptcy, although resulting in sizable losses for a number of market participants, did not lead to the unraveling of the CDS market,” Moody’s analyst Alexander Yavorsky concludes.

Still, he adds that the emergency unwinding of Lehman’s CDS book by major dealers and hedge funds on the weekend preceding Lehman’s anticipated bankruptcy filing demonstrates that the over-the-counter CDS market is “ill-equipped to reliably deal with such events.”

Indeed, Moody’s sees the possible failure of other large CDS market participants as a continuing source of systemic risk. In Moody’s opinion, it is highly unlikely that the CDS market would have been able to deal effectively with AIG also being allowed to fail.

The report also discusses what Yavorsky characterizes as “encouraging progress” among market participants and regulators to move the CDS market, or at least a portion of it, to a central counterparty model. If implemented effectively, a central clearinghouse could substantially reduce, although not completely eliminate, counterparty and trade replacement risks, it said.

IE