Traders' worst fears realised at Lehmans auction

Derivatives traders were yesterday nervously picking their way through the wreckage of the Lehman Brothers bankruptcy in what was the biggest test to date of the unregulated $60 trillion (£35.4 trillion) credit default swaps market.

Investors who had placed bets on Lehman's creditworthiness held an auction aimed at clarifying who owes what to whom after the investment bank went bust four weeks ago, and analysts believe that several hundreds of billions of dollars will change hands.

Credit default swaps are a kind of insurance, which investors used to protect themselves in the event that Lehman defaulted on its bonds. Unlike traditional insurance, however, any financial firm could write a credit default swap contract so banks, insurance companies, hedge funds and traditional fund managers are among those now being required to make investors whole.

The auction set a price for Lehman bonds of 8.625 cents on the dollar. Financial firms that sold credit default swaps, therefore, owe 91.375 cents on the dollar – more than Wall Street had been factoring in. That figure increased nerves about whether everyone in the chain will actually be able to pay the amount that they owe, something that will become clear over the coming days. Participants said the auction went smoothly and efficiently.

The insurance giant AIG was one of the biggest sellers of Lehman Brothers credit default swaps, and it faces big losses as a result. It had to be bailed out by the US government three days after the Lehman bankruptcy filing, and has so far been extended $123bn in loans from the US taxpayer. What investors and regulators fear most is a failure to pay by one link in the chain could cause a cascade of losses through the system.

Analysts say the amount of money that has to change hands could be more than $200bn. Some estimates put the value of outstanding credit default swaps on Lehman Brothers debt at $400bn, although some of these trades have already been netted out because some investors both sold and bought CDS contracts. Exact figures are not available because a CDS is a private contract and is not traded on an exchange, but the payout will certainly be the biggest in the 10-year history of the market.

CDS issuance has exploded in recent years as investors have used the instruments not just to insure bonds that they hold, but also to bet on the creditworthiness of companies. The growth of the market has been so fast that Wall Street has not had time to invent a central trading mechanism.

The New York branch of the Federal Reserve, the US central bank, summoned market participants to a meeting yesterday to discuss creating just such a mechanism. IntercontinentalExchange, the electronic trading platform that is now one of the most popular places to buy and sell oil, said yesterday it had set up a joint venture to create a CDS settlement system. Its announcement came three days after CME Group, which runs the Chicago Mercantile Exchange for derivatives trading, said it was joining forces with hedge fund Citadel to set up a similar system.

Deutsche Borse and NYSE Euronext have also expressed interest, suggesting there could be ferocious competition between exchanges if CDS trading is forced into the regulated arena.