Counterparty Risk in Credit Default Swaps: What Happens when a Broker-dealer Goes Bust?

  • Barclays predicts $80 billion in losses from counterparty CDS defaults in 2008.
  • Bankruptcy code exempts swaps and repos from the automatic stay, giving hedge funds accelerated right to terminate under swap agreements.
  • When selling CDS to a broker-dealer, hedge funds must post up-front collateral and supply additional payments if the reference asset declines in value.
  • Amount and timing of recoverable collateral depends whether broker-dealer liquidates under Chapter 7 or under SIPA.

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