10.20.2011
By Terry Flanagan

Quanto CDS Service Launched

ICAP ReMATCH provides risk service for sovereign credit derivatives.

Sovereign credit default swaps (CDS), or insurance on the debt issued by countries, is often denominated in both euros and dollars to cater to the needs of investors, thereby embedding currency risk into the pricing of the CDS. This risk, known as quanto risk, is being addressed through new technology introduced by ICAP’s ReMATCH.

“In general, banks are taking a more active role in managing the market risk inherent in their portfolios,” Philip Perrott, designer of the quanto solution at ReMATCH, told Markets Media.

Quanto CDS are contracts written in a non -standard currency, e.g., Eurozone sovereign CDS contracts are typically denominated in dollars to avoid the strong correlation between the creditworthiness of Eurozone countries and the value of the euro.

“An example of this is a Quanto sovereign CDS denominated in euros that currently trades at a discount to dollar contracts, because of the embedded currency risk in the event of a sovereign default,” Perrott said. “The spread of the quanto to the dollar contract shows the devaluation risk in the event of the default of the underlying sovereign.”

ReMATCH’s service helps banks reduce their exposure to Quanto risk by using proprietary technology to build accurate mid-level curves and generate risk-reducing trades from the set of portfolio data supplied by participating banks, enabling them to reduce positions that they may otherwise have been unable to exit.

“Whether it is for the quanto or regular rebalancing service in sovereign CDS and other sectors, the residual risks embedded in legacy and trading portfolios are driving demand for ReMATCH’s service,” said Perrott.

While most of the liquidity in the CDS market is focused around the five-year maturity, trading portfolios, whilst facilitating client orders, build up net open positions with maturities that shorten over time and are significantly more difficult to exit.

ReMATCH provides a suite of tools allowing customers to achieve highly controlled and focused results. The new service helps banks reduce their exposure to quanto risk by helping them exit legacy positions that build up in the normal course of trading.

“ReMATCH addresses the problem of minimal or no exit liquidity at these ‘off the run’ points in a trader’s CDS risk profile, and reduces the market risk created by the buildup of these illiquid positions,” said Perrott.

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