The ECB recently published this lengthy report (PDF link) on the state of the CDS market, with particular focus on counterparty risk. It is well worth a read for either a cursory overview or more in-depth look at the mechanics and concerns of that market.
Section 3.4 regarding counterparty risk measures was especially interesting to me. Consider the passage on the use of gross outstanding notional as an indicator of risk (emphasis mine):
The notional amount of a credit default swap refers to the nominal amount of protection bought or sold on the underlying bond or loan. Notional amounts are the basis on which cash flow payments are calculated.
The gross notional amount reported by the BIS is the total of the notional amounts of all transactions that have not yet matured, prior to taking into account all offsetting transactions between pairs of counterparties. As outlined above, gross notional amounts thus represent a cumulative total of past transactions. Using gross notional amounts as an indicator of counterparty risk may be misleading, as many trades are concluded with a single counterparty.
Once negotiated, CDSs bind both counterparties until the agreed maturity. Market participants basically have three choices when increasing or reducing their CDS exposures.
First, they can terminate the contract, provided the counterparty agrees to the early termination. Second, they can fi nd a third party to replace them in the contract, provided the counterparty consents to the transfer of obligations (“novation”). As a third option, dealers that want to unwind or hedge their positions can also enter into offsetting transactions, sometimes (though not necessarily) negotiated with the same counterparty as the hedged deal. The third solution is used extensively, and so the number of trades has surged, resulting in an increase in total gross notional amounts. Indeed, this technique, by contrast with the other two, does not eliminate previous deals and instead adds them together. The end result is that external market commentators tend to pay too much attention to the gross market values in relation to other measures of the real economy such as GDP, whereas net notional amounts, where accounted for, may be downplayed or perceived as being very low or moderate in relative terms given the huge gross notional amounts outstanding.
It's easy to come up with an example which illustrates the problems with gross notionals (the ECB's "third solution"):
Dealer A sells $1mm of protection to Fund X. The gross notional at this time is $1mm, and the maximum that could be lost (in an extreme case with 0% recovery and the original contract transacted at a zero spread) is also $1mm. Now Dealer B sells $1mm of protection on the same name to Fund Y. The gross notional is $2mm, and so is the maximum loss in the market. But what if Dealer B had sold CDS to Dealer A instead? Then the gross notional would still be $2mm, but only $1mm could be lost, as Dealer A has hedged its position completely. Thus, gross notional has overstated the risk present in the marketplace.
Net notional is a much better measure, but, in line with my parenthetical aside, does not quite capture the risk at hand; it only does so under extreme circumstances. (It also isn't nearly as dramatic a number, so the media is more loathe to deal with it.)
In my experience, jump to default (JTD) and jump-or-bleed to safety (JTS) measures are instructive methods for evaluating risk. Most commonly, these measures are evaluated with respect to the reference issuer, but they are easily applied to the counterparty as well. However, calculating them in aggregate - at the market level - requires knowledge of the various contracts' market values, data which is not presently made public (gross and net notional values are available from the DTCC).
Finally, the ECB makes the salient point that any market-wide counterparty risk measure must account for collateralization. There is some ambiguity there, however, because a contract which is fully collateralized on a mark-to-market basis still has considerable counterparty risk in a jump event. Frequently, protection buyers may find that to be wrong-way risk, meaning that the exposure to a counterparty is inversely related to that counterparty's credit rating. For example, a counterparty defaults, driving credit spreads wider (a profitable event for the protection buyer) but also making other counterparties more likely to default (a very bad thing for the protection buyer).
In failing to find a clear, universal or simple risk metric for this market - which I don't think is necessarily preferable given the over-reliance and under-comprehension placed on VaR after its wide dissemination - we may find that the best outcome is to strive for transparency in understanding. A strong education in the mechanics and risks of complex markets is an important step forward and a necessary prerequisite for market participants in both direct and regulatory roles.