The credit default swap market has suffered years of declining volumes, thanks to regulatory burdens and the quiet economic cycle. However, as idiosyncratic risk rises, there is a new feeling of optimism among credit traders. Can the CDS market bounce back? 

The single-name credit default swap (CDS) market currently finds itself stuck slap bang in the middle of a particularly nasty Venn diagram, afflicted by overlapping factors that have shrunk liquidity and pushed some market-makers out of the business – unfavourable economic conditions, tougher regulations and uncertainty over new market structures, to name a few.

Bald statistics tell the story well enough. In the second half of 2011, according to data gathered by the Bank for International Settlements, the total global notional value of single-name CDS contracts stood at $18,100bn (see chart 1). By the first half of 2015, this had fallen to $8200bn. Over the same period, the gross value of the market fell from $958bn to $278bn.

Back to life?

Credit traders can take some small crumb of comfort from the fact that theirs is not the only market to have suffered over the past few years. Liquidity is down across the board, from the most exotic derivatives trades to even trusted stalwarts such as German bund futures or US treasuries.

However, unlike many financial instruments, single-name CDS remains vital to the safe functioning of the market. While the slow death of many esoteric types of derivatives has gone largely unmourned, CDS is seen as worth defending by participants on the sell-side and buy-side. Users claim that it remains the best way to hedge against precise credit risks, and the best way to express a position on a particular credit in the market. 

As a result, the industry has banded together to help pick the single-name market up, dust it off, and get it back to a healthier state. Last May, BlackRock led a large number of other major buy-side participants in a pledge to make CDS work more efficiently, and in December made a strong commitment to CDS clearing. The International Swaps and Derivatives Association (ISDA) has also brought in technical alterations to CDS trading processes in an attempt to further boost liquidity.

“When we talk about liquidity problems in CDS, it is important to remember that we’ve seen lower liquidity across almost every area of trading, not just in credit. In fact, single-name CDS activity has held up better than some. We are seeing strong activity among corporate names, and in emerging market sovereigns,” says Francois Popon, co-head of European CDS trading at Société Générale in London. “Overall, I am very optimistic for the market.” 

Cause for optimism

This optimism stems from a gradual change in the economic cycle, with individual, idiosyncratic credit risks likely to come to the fore. The long period of low rates and low volatility that set in after the financial crisis produced a focus on macro risk, but now that this is coming to an end, investors should see more defaults, and therefore should have more reason to take on accurate credit protection. Single-name CDS is still, more than 20 years after the invention of the instrument, the best way to do this. Index CDS, which generally contain a basket of credit names from a particular sector or region, offer a cheaper route to credit protection, but can often be an inefficient hedge against specific defaults. 

“Using CDS indices was very popular when the market was trading on a macro basis. Now we are seeing individual credit stories and concerns coming to the fore, and using a CDS index in this environment is sometimes not optimal. Single-name costs have increased, but not to the extent that seeking a perfect hedge has become economically unviable,” says James Duffy, head of single-name CDS trading for Europe, the Middle East and Africa at Citi in London.

Although overall CDS volumes have fallen lower and lower, there can still be enormous activity around specific credit events, proving that the single-name market remains an attractive prospect at the right times. The Volkswagen emissions scandal, which broke in mid-September 2015, illustrates this perfectly. With the embattled car company potentially facing a rash of damaging lawsuits as a result of its manipulation of emissions data, market sentiment towards its creditworthiness took a battering. According to data supplied by Markit, the cost of a five-year CDS on Volkswagen ballooned from 75 basis points (bps) by close of play on Friday September 18 to 134bps the following Monday. It reached a peak of 300bps on September 29, and had settled to 180bps by January 14. 

Glencore, the mammoth commodity trading and mining company, offers another good example of focused CDS market activity over a slightly longer period. The firm has struggled to adapt to falling commodity prices and, laden with tens of billions of dollars in debt after its merger with xStrata in 2013, saw its share price tumble throughout 2015 and it issued a profit warning at the start of 2016. After starting 2015 at about 150bps, the five-year CDS on Glencore edged upward to reach 229bps by the end of July. After that, as worries about its profit prospects escalated, the spread widened more quickly, reaching 1044bps by January 14. 

“We saw a large uptick in activity in the week of the Volkswagen scandal last year. There was a high standard deviation move in the weekly volume, with more than $4bn of notional traded,” says Mr Duffy. “A CDS is a classic bear market instrument and, with idiosyncratic risk on the rise, it feels as though CDS volumes have bottomed out.”

Notional amounts outstanding of single-name CDS Market

Regulation drag

Bottomed out, perhaps, but unlikely to recover to the levels seen in years gone by. The economic cycle might be moving in the instrument’s favour, but it is still weighed down by the regulatory changes that have had such a deadening effect across the derivatives markets. Under the Basel 2.5 and Basel III reform packages, banks must hold far more capital against their derivatives books, thereby raising costs and reducing the amount of balance sheet available for market-making. 

Basel III’s leverage ratio has also restricted CDS trading. “Under the leverage ratio, there are additional costs related to your full forward notional that apply to credit derivatives but not to other derivative markets. Under Basel III, banks also have to hold an increased amount of capital against counterparty exposures, so having a large CDS book is heavily penalised,” says Saul Doctor, a credit strategist at JPMorgan in London. 

As a result, buyside participants have found it more difficult to execute sizeable CDS deals. “One of the most common complaints we get from clients is that it is harder and harder to get a good price on a single name when the market is quiet. Before the decline in liquidity set in, you could easily execute a $60m CDS on a high-grade name for 50bps. Now, people aren’t interested in doing that due to the effects of higher capital requirements,” says one credit trader.

“You frequently see clips of between $50m and $100m going through on specific names if there is some credit event around that name, but on normal market days trades of that size are much rarer,” he adds.

The blame game

The CDS market has also had to face the ire of legislators. At the height of the eurozone sovereign debt crisis, embattled politicians believed that CDS speculation was reducing the perceived creditworthiness of several peripheral states, and therefore contributing to higher borrowing costs. In November 2011, the European Parliament voted to ban ‘naked’ CDS trading – that is, taking on a single-name CDS contract without owning the underlying bonds of the entity.

Dipping further back into history, rampant activity in the CDS market is also blamed for magnifying the losses of many financial institutions during the 2007-08 crisis, leading most notoriously to the near-failure of the insurance giant AIG.

Shaking off these negative attitudes is part of the reason why central clearing is deemed to be so important for the CDS market. The goal of routing all standardised over-the-counter derivatives trades through central counterparties (CCPs) was established at the Pittsburgh G-20 summit in 2009, but a series of legislative and regulatory delays in the US and Europe meant that it took some years for clearing mandates to be attached to various instruments. In Europe, for instance, CDS clearing for current CCP clearing members is not expected to begin until the end of this year at the earliest, after which it will be phased in for other types of counterparties.

Though many in the industry recognise these changes as fair and necessary from a risk management standpoint, clearing has often been viewed as a costly, logistical burden. “I think we still need to fight a slightly sceptical attitude toward clearing. It may result in a bigger initial cash outlay, but it will definitely improve the overall health of the CDS market. From an individual trade perspective, clearing is often not optimal, but on a portfolio perspective we can find much greater efficiencies if we can clear everything,” says Mr Duffy at Citi.

Opening up

It is hoped that, by making the CDS market more transparent and less risky, smaller participants who may currently prefer safer but less perfect hedges in the credit futures or CDS index markets will gravitate towards single names and give a boost to liquidity and volumes. Even without the mandates, clearing is imperative from a bank’s perspective. Basel III introduced the credit valuation adjustment (CVA) charge, an extra amount of capital that must be allocated to a trade to cover counterparty credit risk. Clearing mitigates this charge, and without it the charge can make the capital costs of engaging in derivatives markets too punitive.

Alongside clearing, there have also been less high-profile, smaller scale improvements to the single-name CDS market. One such technical fix has been brought through by ISDA to change the frequency of CDS ‘rolls’. In a single-name CDS, the five-year tenor is the most popular and most liquid. To maintain a permanent five-year hedge on a particular name, CDS contracts are periodically ‘rolled’ forward on to new ‘on the run’ contract dates.

Under the old convention, this happened once per quarter on March 20, June 20, September 20 and December 20. This provided a great deal of flexibility, but also fragmented CDS liquidity across these four dates, resulting in a higher number of different instruments than was strictly necessary. It can also introduce higher costs. As one credit dealer explains, rolling a CDS contract may cost five basis points each quarter, totalling 20 basis point across the year. For a single-name CDS book of, say, $100m, that equates to $200,000 of extra transactional costs per year. 

ISDA’s solution was to reduce the number of yearly rolls from four to two, falling in September and March. “The move to semi-annual rolls isn’t going to result in a big spike in CDS volumes, but it could be a useful technical fix that irons out one of the wrinkles in the market. With more roll dates you have a greater number of different contracts, and less ability to focus liquidity. It’s likely that we’ll have to wait until perhaps this time next year to feel the full effect of the change from a liquidity point of view,” says Mr Doctor.

Too late?

The new mood of optimism for single-name CDS has come too late for some banks. In 2014, Deutsche Bank announced that it would pull out of the credit derivatives market in general, and in reality only a few large banks currently have significant capacity for single-name CDS market making.

“Banks that have already unwound their credit businesses may come back to the market and start afresh when times are better, but if not there may be a capacity problem in CDS,” says Kevin McPartland, head of market structure and technology at US advisory firm Greenwich Associates.

“The banks that have stuck it out in the CDS market will likely benefit in the long run. As for the banks that have left the market, they faced a difficult choice as they have had to meet immediate shareholder demands for higher returns, while trying to judge what would and wouldn’t work in the long run. At a time of unprecedented structural and regulatory change, it is very difficult to square that circle.”

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