Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 4 October 2012

The sorry state of the CDS market

The days when every banking graduate wanted to be on the credit trading or structuring desk are long over. From being feted as sophisticated tools which dispersed risk and contributed to “enhanced resilience” of banks, CDS became the chief culprit behind the financial crash. AIG’s mindless use of CDS not only sealed its fate but also crystallised public perception of CDS which continues to this day. CDS are now the evil speculator’s weapon of mass destruction.   

This perception problem coupled with the collapse of the structured credit machine has largely contributed to the CDS market declining to new low (as measured by gross notional outstanding). As Graph 1 shows, gross notional outstanding is the smallest it has ever been since the end of 2005.

Graph 1

Source: ISDA, DTCC

Of course, it can be argued that gross notional is misleading due to the post-crisis trend towards trade compression and central clearing (see box).

Assume 3 banks (A, B, C) and 1 hedge fund (H) trading CDS on Company X.
H buys $10m notional of CDS from A and A then buys from B who buys from C.
Gross notional = $30m = $10m(H&A trade) + $10m(A&B trade) + $10m(B&C trade)
Net notional = $10m (On a net basis, H has bought and C has sold. A & B are neutral)
What trade compression does is cancel out the 2 trades: A & B and B & C leaving H facing C directly on the CDS.
Similarly central clearing will automatically cancel out the 2 trades as all trades are made with the central clearer so A & B’s buying and selling to the clearer will cancel out.
Therefore compression and central clearing can lead to gross notionals falling even though the market has not shrunk.

However, DTCC data on the top 1,000 traded entities shows that net notional has been falling since the crisis even as gross notional fluctuates. In October 2008, the earliest data is available on DTCC, net notional was 10% of gross notional. The most recent data on 14-September-2012 shows that net notional shrunk to 7.5% of gross (Graph 2). This implies that the fall in net notional, and hence the market, has been even more severe than Graph 1 shows.

Graph 2

Source: DTCC

As the market has shrunk there has been a consequent decline in liquidity. Although quite apparent to traders, it can also be gauged from the maturity profile of outstanding CDS (Graph 3). In fact, the maturity profile is quite interesting. It indicates how trading has moved almost exclusively to the 5-year contract while both 5 and 10-year contracts were traded earlier. 

Graph 3

Source: DTCC

The 2008 maturity profile (yellow, red) shows two humps at 2012-13 (the then 5-year contract) and 2017-18 (the then 10 year contract). Post crisis recovery did not lead to a revival in 10-year trading. This can be plainly seen from the June 2010 profile (purple, brown). The 2017-18 outstanding contracts and notional remained almost the same as 2008 and the 2015 (then 5-year) increased. Now the hump in contracts has shifted to 2016-17 (corresponding to 5-year in 2011 and now) with notional and contracts in earlier maturities being fairly constant from June 2010. This is consistent with the fact that barring a few ‘whales’, everyone else is primarily trading the on-the-run 5-year contract. And there are fewer trades going through. The outstanding 5-year contracts in 2010 were lower than 2008 (compare 2013 vs 2015). And lower still in 2012 (were it not for the legacy 10-year deals, both notional and contracts in 2017 would be lower than 2015). 

So what does it all mean? Reports on the death of CDS may be exaggerated but the market is definitely caught in a downward spiral. The good news is that financial products once created seldom die. CDS do play a role in risk mitigation and distribution as long as institutions do not attempt to emulate AIG. Although much has been made of the fact that CDS is primarily traded between dealers but this is to be expected since institutions which run the largest credit risk (apart from the ECB) are banks. The bad news is that regulation, collateral requirements (due to central counterparties and more stringent CSAs) and capital charges are going to limit CDS use on bank trading books. Moreover, the whale’s demise is also going to curtail their popularity as hedges for unrelated risks (one hopes this to be the case but the primary purpose of hedging is regulatory gaming not reducing risk so a whale here and there may be ignored as a tempest in a teapot).

After an exponential rise, a logarithmic decay seems to be in store for these vilified financial weapons of mass destruction. For the incoming batch of banking graduates, they are this decade’s equivalent to ‘equities in Dallas’. Politicians would do well to choose another scapegoat quickly in case a crisis flares up again. 

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