Tuesday, September 25, 2012

The shrinking corporate CDS market

The Dodd–Frank financial reform is killing the single name corporate CDS market. Liquidity in this market is drying up quickly. This is due mostly to dealers' inability to take positions when they make markets (Volcker Rule) and a cumbersome clearing process that will impose higher margin on corporate CDS for end-users (in some cases higher than the equivalent positions in corporate bonds via repo). In fact the business of basis trades - bonds vs. CDS - is no longer viable in many cases because of the margin requirements on both sides and no ability to offset.

The fact that dealers who clear CDS are not expecting this business to be profitable (see discussion) is not helping either. And single name CDS regulated by the SEC while indices such as CDX regulated by the CFTC adds to the uncertainty. At the same time margin and clearing rules differ materially among the clearinghouses (ICE, CME) and trades are not fungible between them (a trade cleared on the CME can not be offset with the opposite trade cleared via ICE). This uncertainty is adding to this decline in liquidity. The situation is so bad that an index of 100 CDS doesn't have enough liquid CDS for the index to be formed.
FT: - Indices that track the price of credit default swaps (CDS), contracts which act as insurance against a default on corporate bond payments, have become a popular way for banks and hedge funds to speculate on the creditworthiness of American companies and for bond fund managers to hedge risks in their portfolio.

But underlying CDS trading has shrivelled to such an extent that there are not enough actively traded names to make up a 100-company index.
This takes us back to the question of making the financial markets "safer". Not a single institution has ever failed due to a problem with corporate single name CDS. But banks and corporations do use this product to hedge all sorts of things - including receivables, counterparty exposure, reducing loan exposure to a single company, etc. It's not at all clear therefore how nearly eliminating this market through blunt regulation will be helpful for the financial system or the economy as a whole.

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