Barclays Capital says CDS counterparty failure could cause $47 billion of losses

Barclays Capital has published a research reported entitled "Counterparty risk in credit markets" which estimates the likelihood of simultaneous default by a counterparty and a reference entity. The analysts conclude that expected aggregate losses to protection buyers in that scenario are at the lower end of the scales discussed. But that there are other concerns beyond losses to protection buyers, such as loss of mark-to-market gains and gap risk in other OTC derivatives.

The report calculates that based on spreads on 25 January this year, the cost of counterparty risk in spread terms ranges from 9 basis points for protection bought from a double A counterparty on a triple A credit to 120bp for protection on a B+ rated credit from an A- counterparty. This analysis ignores the benefits of collateral arrangements and netting.

The same methodology based on credit spreads from one year ago produce a much lower cost of counterparty risk - ranging from 1bp to 7bp.

The report goes on to analyse the impact on the financial system of a failure by a major credit derivatives counterparty. Barclays Capital calculates that if a counterparty with $2 trillion of CDS contracts outstanding defaulted, it could result in losses of between $36 billion and $47 billion for the institutions' counterparties because of the likely re-pricing of credit spreads following such an event. However, netting could significantly reduce these losses, say the researchers.