Saturday, May 12, 2012

Monopolistic CDS pricing practices or hype from Kamakura

Donald van Deventer of Kamakura published his latest paper entitled "The Credit Default Swap Market and Anti-Trust Considerations" (ht Ed Grebeck, Tempus Advisors). Here are some quotes from their conclusion.
"The credit derivatives market shows a very high degree of concentration and that high level of concentration has persisted since 1998. There are only three significant credit derivatives counterparties among U.S. commercial banks as of September 30, 2011."
What a revelation! Mr. van Deventer, would you do a CDS transaction with Jefferies (nothing against that institution by the way)? How about Abacus Federal Savings Bank on Canal Street? Unlikely. End-users of CDS only want to transact with the largest well capitalized institutions that are expected to be around for a while. And there are not many of those left in the US. People still remember having CDS positions on with Lehman. Many of these CDS trades were in-the-money but there was nobody on the other side to allow end-users to realize profits. Unrealized profits became unsecured claims in the Lehman bankruptcy court. That's the reason for the concentrations.
"This raises the possibility of collusion, market manipulation, and monopolistic pricing practices."
Monopolistic pricing practices? Mr. van Deventer, you obviously think CDS is an insurance contract and these big banks are only sellers of "insurance" and thereby they overcharge end-users. But here is some news for you. CDS is not insurance - it's a two-way market. This is like saying that stock put options are always sold by brokers and always bought by end-users. If these "monopolies" quote too high of a spread on CDS protection, hedge funds will be more than happy to sell them some CDS and pocket the premium. Just as people do when put option premiums get too high.

The critical point that was completely missed in this write-up is that having fewer dealers making markets has resulted in significantly lower liquidity for the product. And the liquidity problem is only getting worse. But the paper goes on:
"We urge regulators and the Department of Justice to apply maximum scrutiny to the credit derivatives market in the United States, as authorities in the European Union have begun to do."
Everyone quickly call the Department of Justice (because they have nothing else to do) and then go out and buy the patriotic Kamakura software. Yes, with the SEC, the CFTC, and the Fed all trying to figure out which way is up, now you want to bring in the Department of Justice.

Here is some more news for Mr. van Deventer. With the clearinghouse coming online this year, the dealers will become increasingly less relevant, particularly for index CDS (such as CDX). Over time there will be no liquidity on anything that is not cleared.  Interdealer brokers such as Phoenix Partners will get into the business of end-user CDS brokerage (as they've done with stock options), and the concentration issue will go away on its own.

But the clearinghouse solution just doesn't sound as patriotic as calling on the Department of Justice. Congratulations goes to Donald van Deventer and Kamakura for getting the latest Sober Look Hype Award.


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