The future of the credit default swaps market has been a hot topic of late.
Since 2008 these derivatives, which essentially give investors a way to bet on the creditworthiness of a single company, have fallen out of favor. They were blamed for exacerbating the impact of the financial crisis and were often used in conjunction with collateralized debt obligations, or CDOs, which ended up causing huge losses for investors following the bursting of the housing bubble.
Since 2008, financial regulators have imposed new rules on the market, requiring many types of derivatives to be centrally cleared, and also imposing new regulation that makes it more expensive and more difficult for big banks to deal in the instruments. Net wagers in single-name CDS have subsequently dropped to $686 billion from more than $1.58 trillion in late 2008, when the Depository Trust & Clearing Corp. first started reporting positions in the swaps. As Bloomberg News reported last month, some big investors including BlackRock are now pushing to restart the market.
Last week Citigroup asked big investors and traders what they think is needed to jump start the market.
The results of the survey are … unsurprising.
About 36 percent of respondents felt lighter capital requirements and less stringent leverage ratios — two of the biggest post-crisis rules imposed on large banks — were the best way to improve volumes. Some 35 percent felt a push to centralized clearing would be the best solution. Unlike CDS written on credit indexes, single-name swaps are not yet required by regulators to be cleared.
Why aren’t more single-name CDS being centrally cleared is a natural follow-on question. About 36 percent of respondents said that the sometimes hefty collateral traders are required to post at clearing houses to back their trades had slowed the switch to clearing. Meanwhile, Citi says, “33 percent of respondents pointed to a lack of coordination among market participants in organizing a collective shift for the lack of universal centralized clearing.” That’s probably a nice way of saying single-name CDS aren’t being centrally cleared because the industry hasn’t gotten its act together.
Lack of coordination and compulsion has stymied the move to universal centralized clearing. Most of our respondents noted the benefits of central clearing, and its’ likely positive impact on trading volumes. Indeed, given that most indices are now cleared centrally, achieving the same for single-name CDS seems the next logical step. However, centralized clearing for single names is not currently mandated, and there is no guarantee that all market participants will follow the move to centralized clearing unless forced to. Hence, for the marginal market participant, given the lack of immediately obvious benefits from switching to clearing every trade centrally, there seems to be relatively little incentive to be the first mover. Our respondents generally continue to call for a formal market-wide push to get the ball rolling.
Intriguingly, there are some who think that what’s needed to boost the market is a return of synthetic CDOs, issuance of which has fallen off a cliff in the aftermath of the crisis. Synthetic CDOs once sold huge amounts single-name credit protection, attracting a bunch so-called correlation traders who would profit from tiny discrepancies between the swaps and parts of the CDOs known as tranches. With few of these CDOs now being created, most of these correlation traders have disappeared from Wall Street. Though we’re guessing, based on the below, that at least a few survive.
An interesting recommendation some people made was to stimulate the CDO market to help boost single-name CDS trading … CDS outstandings were highest during the periods where the most CDO trading took place. The argument was made that following the financial crisis, an environment with tighter regulatory requirements emerged and both CDO and CDS volumes fell. To us, it isn’t as clear cut as that and we don’t think the fall in CDO volumes is the key driver of the volumes in the single-name CDS market. However, the logic that as tranche volumes rise and banks have more assets to hedge, causing more single-name trading does seem plausible, and we suspect CDO volumes have had some impact.
APAC Financial Markets • #CDS, #CollateralizedDebtObligations, #CreditDefaultSwaps, #Derivatives, #ISDA, #Regulation, #Risk, #Rules, #SingleNameCDS #MarketNews
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