Financial News
         CDS market has become a shadow of its former self


         Simon Boughey
         16 Nov 2009

Broker GFI’s monthly credit derivatives report used to create a stir in the market. The report, which charts trading patterns in the most active sectors and single-name credits in the global credit default swap market, contained some diverting information this month.

Financial credits, for example, continue to be heavily traded, but in Europe the fixed-line telecommunications sector could not be knocked off its perch as the busiest area of the market.

Three of the five most active names in the European market in October were telecoms credits: Vodafone, British Telecom and Telecom Italia.

In the US market, meanwhile, uncertainty about the future of CIT Group, a key lender to small and mid-sized companies that filed for bankruptcy on November 1, meant the firm was a heavily traded credit last month.

The biggest mover in the European market was Société Air France, which narrowed by 37%, while financial credits of Kazkommertsbank, Aiful and Mizuho dominated the Asian CDS market.

Reading this monthly report feels rather like studying the archives of a lost civilisation, once culturally significant, but then largely destroyed in a huge and as yet not fully understood cataclysm.

Just over a year ago, the CDS market was a big news item. Levels of the iTraxx indices – the main baskets of CDS credits used in Europe – were quoted at length by all sections of the financial press.

This was the instrument that seemed to present the clearest and most unalloyed snapshot of the creditworthiness not only of individual firms but also of the entire market. Cash bonds, in contrast, were sluggish, slow to react and just a bit old fashioned, the dinosaurs of the capital markets. CDS was where it was at.

Twelve months on, the CDS market is a shadow of its former self. Its notional principal, which reached the dizzying figure of $62 trillion at the end of 2007, according to data from the International Swaps and Derivatives Association, had halved to $31 trillion by the end of the first half of this year.

Assessments of notional principal outstanding give a misleading impression of the true depth of the market and the sharp fall over the past two years is due largely to trade compression and netting agreements, but there is no getting round the fact that trading volumes have dropped alarmingly this year. Veteran CDS traders in London concede that they see only one fifth of the business they saw in the halcyon days of 2006 and 2007.

“There are no volumes and no interest,” concluded the head of credit derivatives trading at a London firm last week.
There are several reasons for the collapse in volumes. The first and most important is the demise of the structured market.
Until the middle of 2007, banks printed masses of synthetic credit product. It seemed no week could pass without CDS desks in London and New York being asked to give prices on a series of bid lists for collateralised debt obligations.

There were increasingly imaginative and baroque variations on that theme, such as the CDO squared, the CDO cubed, collateralised loan obligations and, finally, the constant proportion debt obligation. It is estimated that in 2006 more than $500bn of CDOs were priced globally, and all needed the CDS market for structuring and hedging.

The technical bid was in part responsible for the consistent rally of the iTraxx investment grade indices until 2007, so that before the crisis the iTraxx Europe was dealing below 20 basis points. With the implosion of the structured market, the CDS market has been starved of that source of liquidity.

At the same time, the number of participants and potential counterparties in the market has declined substantially.
Some houses have collapsed, others have been merged. The hedge funds were some of the biggest users of the CDS market, and their scope has been much reduced over the past 18 months.

Another London CDS veteran said last week: “It’s now like five friends getting together round a poker table. We’re just passing the exposure back and forth.”

Those shops that remain are much more risk averse than they once were and are forced to post more collateral than before. If regulators have their way, there will be further drastic changes. The CDS market has been forced to accept central clearing, but they may be forced to accept exchange trading as well.

Not only will this mean greater price visibility and lower profit margins, corporate users are likely to be deterred by the need to post collateral, thereby depriving the market of another user base. One or two legislative initiatives have raised the possibility of a ban on naked trading, which would, in effect, kill what remains of the market.

Perhaps most tellingly of all, no one really seems to bother about CDS any more. There was a time when corporate treasurers would worry daily about where their firms’ CDS was trading. They don’t care now, as CDS prices give no substantive clue about where they could raise debt in the wholesale markets.

It had become common for new bond issues to be quoted against CDS rather than cash bonds, particularly in the European markets, which have a less deep and mature fixed-income market than in the US. But no one does that any more, and no one assesses the value of a bond against CDS.

The latter has become too illiquid and dysfunctional for this analysis to provide any useful information about value.
The CDS market has suffered a fall from grace that has been both precipitous and rapid. London traders hope a revival may be under way. Loan books will get more active at some date and this may galvanise the CLO sector. But it will never be what it was in the summer of 2007, when these little-understood but much-quoted instruments seemed to hold the key to the financial universe.

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© Simon Boughey

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