Tag Archives: portfolio compression

Crimping CDS

The post-crisis CDS market has undergone significant regulatory change including a substantial regulatory overhaul due to the Volcker Rule, requirements from reporting to central clearing under the Dodd–Frank Act and the European Markets Infrastructure Regulation (EMIR), and Basel III capital and liquidity regulations. Measuring the size of the market consistently is notorious difficult given different accounting treatments, netting protocols, collateral requirements, and legal enforceability standards. Many organisations have been publishing data on the market (my source is the BIS for this post) but consistency has been an issue. Although a deeply flawed metric (due to some of the reasons just highlighted and then some), the graph below on the nominal size of the CDS market (which updates this post) illustrates the point on recent trends.

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The gross market value (defined by BIS as the sum of the absolute values of all open contracts with either positive or negative replacement values) and the net market value (which includes counterparty netting) are better metrics and indicate the real CDS exposure is a small fraction of the nominal market size, as per the graph below.

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Critics of the regulatory impact on the liquidity of the CDS market argue that these instruments are a vital tool in the credit markets for hedging positions, allowing investors to efficiently express investment positions and facilitating price discovery. A major issue for liquidity in the market is the capital constraints imposed by regulators which impedes the ability of financial institutions to engage in market-making. The withdrawal of Deutsche Bank from the CDS market was seen as a major blow despite some asset managers and hedge funds stepping up to the mark.

The impact of rising interest rates in the coming years on the credit markets will likely have some interesting, and potentially unforeseen, consequences. With a plethora of Goldman Sachs alumni currently working on Trump’s “very major hair cut on Dodd-Frank”, amongst other regulations, it will be interesting to see if any amendments lead to a shot in the arm for the CDS market. Jamie Dimon, in his most recent shareholder letter, calls for an approach by Trumps’ lieutenants “to open up the rulebook in the light of day and rework the rules and regulations that don’t work well or are unnecessary”.

 

June 2020 Update – Below is the CD graph updated to the end of 2019. For Ingrid.

Size of notional CDS market from 2001 to 2012

Sometime during early 2007 I recall having a conversation with a friend who was fretting about the dangers behind the exponential growth in the unregulated credit default swap (CDS) market. His concerns centred on the explosion in rampant speculation in the market by way of “naked” CDS trades (as opposed to covered CDS where the purchaser has an interest in the underlying instrument). The notional CDS market size was then estimated to be considerably higher than the whole of the global bond market (sovereign, municipal, corporate, mortgage and ABS). At the time, I didn’t appreciate what the growth in the CDS market meant. Obviously, the financial crisis dramatically demonstrated the impact!

More recently the London Whale episode at JP Morgan has again highlighted the thin line between the use of CDS for hedging and for speculation. Last week I tried to find a graph that illustrated what had happened to the size of the notional CDS market since the crisis and had to dig through data from the International Swaps and Derivatives Association (ISDA) to come up with the graph below.

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Size of notional CDS market 2001 to 2012

Comparing the size of the notional CDS market to the size of the bond market is a flawed metric as the notional CDS market figures are made up of buyers and sellers (in roughly equal measures) and many CDS can relate to the same underlying bond. Net CDS exposures are only estimated to be a few percent of the overall market today although that comparison ignores the not inconsiderable counterparty risk. Notwithstanding the validity of the comparison, the CDS market of $25 trillion as at the end of 2012 is still considerable compared to the approximate $100 trillion global bond market today. The dramatic changes in the size of both the CDS market (downward) and the bond market (upward) directly reflect the macroeconomic shifts as a result of the financial crisis.

The financial industry lobbied hard to ensure that CDS would not be treated as insurance under the Dodd-Frank reforms although standardized CDS are being moved to clearing houses under the regulations with approximately 10% of notional CDS being cleared in 2012 according to the ISDA. The other initiative to reduce systemic risk is portfolio compression exercises across the OTC swap market whereby existing trades are terminated and restructured in exchange for replacement trades with smaller notional sizes.

Although the industry argues that naked CDS increase the liquidity of the market and aid price discovery, there is mixed research on the topic from the academic world. In Europe, naked CDS on sovereign bonds was banned as a result of the volatility suffered by Greece during the Euro wobbles. The regulatory push of OTC markets to clearing houses does possibly raise new systemic risks associated with concentration of credit risk from clearing houses! Other unintended consequences of the Dodd Franks and Basel III regulatory changes is the futurization of swaps as outlined in Robert Litan’s fascinating article.

Anyway, before I say something silly on a subject I know little about, I just wanted to share the graph above. I had thought that the specialty insurance sector, particularly the property catastrophe reinsurers, may be suited for a variation on a capital structure arbitrage type trade, particularly when many such insurers are increasingly using sub-debt and hybrid instruments in their capital structures (with Solvency II likely to increase the trend) as a recent announcement by Twelve Capital illustrates. I wasn’t primarily focussed on a negative correlation type trade (e.g. long equity/short debt) but more as a way of hedging tail risk on particular natural catastrophe peak zones (e.g. by way of purchasing CDS on debt of a overexposed insurer to a particular zone). Unfortunately, CDS are not available on these mid sized firms (they are on the larger firms like Swiss and Munich Re) and even if they were they would not be available to a small time investor like me!