Back in October I wrote about the impact of an impeding Greek default on the CDS market. I concluded that in the shadow of Dodd-Frank, the decision on whether the Greek bailout triggered a CS payout was a minimal consequence.
With ISDA’s announcement that the European Central Bank’s fix to the Greek bond crisis will not cause CDS contracts to pay out, it seems we will quickly find out how right or wrong I am.
Economically, the announcement today is of minor consequence. According to the Wall Street Journal, the maximum payout would be only $3.2 billion. That amount is certainly not on the radar of systemic risk watchers.
The real issue here is the viability of sovereign CDS. If the market is now left thinking that anytime a sovereign default is inevitable the relevant regulators will structure the event in such a way that it is not technically a default, why buy the CDS at all?
I suspect many of us feel this way about auto insurance – if your policy won’t pay unless your car crash happened on a dirt road on a Tuesday between 11 a.m and 12 p.m., what’s the use? Seems we might be in that place for sovereign CDS.
Rather than reiterate my thoughts, I wanted to bring back attention to the piece I wrote in October: Greece Won’t Kill CDS, Dodd-Frank Will.
My comments on the subject were also picked up by the Wall Street Journal: “CDS, Huh. What It Is Good For? Absolutely Nothin?” Read their coverage at WSJ.com.
If Congress really had its way (well, the Democrats anyway) than all swaps would have been forced to look and trade like futures. If you’re reading this blog than you know that would be a classic square peg, round hole. Case in point: Eurex launched iTraxx futures some years back and no liquidity every developed. But times have changed, and although I’m not completely convinced the world needs credit-default swap (CDS) futures, the upside if the contracts are successful is big enough that it is nearly inevitable that they will come to market ahead of CDS trading and clearing mandates later in 2012. Why?
Firstly clearinghouse margin requirements for CDS are seen by many as unnecessarily high. Complications related to clearing sovereign and bank CDS, two of the most highly used CDS segments, will leave margin requirements for those products even higher than for index CDS. These high margin requirements alone could open the door for CDS futures as the margin requirements for futures are tracking much lower than for comparable swaps.
Hence my comments to Dow Jones. CDS futures won’t take off just because the market wants to take directional bets on credit, they’ll take off because they provide an economic incentive to those wanting to take direction bets on credit:
Kevin McPartland, principal at the independent research firm TABB Group, said these so-called “liquidity” issues would drive more trading in CDS and “that would only translate to demand for CDS futures” so long as they offered some economic benefits over the existing swap contract.
A dealer working on the CDX futures project said it could be a solution that would drive volumes because the contracts could be traded in smaller sizes than CDS, and this could appeal to investors not currently trading in swaps. “It’s something that makes sense,” he said.
Over the last few weeks the topic of CDS futures has come up a bit in my conversations with industry participants. In fact we discussed this back stage at our recent Fixed Income Trading 2012 event in New York on January 24th. Everyone seems convinced that several firms are “working on the problem”. However, a TABB Group estimated 80% of CDX.IG trading in the interdealer market happening electronically based on a highly standard contract (remember the Big Bang in 2009?) begs the question, with such a standard, relatively liquid market already in place why do we even need a future? Its nothing more than a different regulatory rubber stamp calling the product one thing over another.
It can even be argued that margin rates for cleared CDS and the comparable cleared CDS future should be the same. If they’re economically equivalent than why wouldn’t margin requirements be equivalent? That point leads to another discussion that I’ll come back to in the coming months.
The bottom line – someone will bring CDX.IG futures to market, but betting on their success is purely a game of chance. Only time will tell.
It seemed like the CFTC’s meeting yesterday (Dec 12th) would be a big one; we’d find out the size of a block trade and in doing so get some insight into how truly electronic the swaps market would become. Â Unfortunately, the can has been kicked down the road again. Â Instead we have a seemingly temporary 30 minute reporting delay for all trades (until block trades are defined) and confirmation that all trades must be reported (a noÂ brainer).
My comments in the Wall Street Journal could have used a little qualifying, as they sound a bit generic out of context (of course market data exists today), but if you’ve read any of my other research you know where I’m coming from. Â Here’s to hoping this market actually can get moving in 2012.
Swaps market analyst Kevin McPartland, a principal with research-firm TABB Group, said the new rules will greatly increase amount of available data on each trade. “We’re going from a world where there was almost no market data to a world where it will be regulated into existence,” Mr. McPartland said, adding that now “everyone will have streaming data on these markets.” He estimates that the Dodd-Frank derivatives regulations will cost the industry $1.8 billion in total but hasn’t separated out the cost for the data rules.
Read the full story here:Â http://on.wsj.com/tszLKA
The slow regulatory process has its first known victim. As soon as Dodd-Frank made swap execution facilities official, entrepeurial swaps traders everywhere thought they better hurry up and start one. But as we’re seeing only those with deep enough pockets to keep operating for months (or years) with virtual no profit until regulations are in place will survive. I spoke with Diamond OTC maybe 6 months ago – although their differentiation strategy wasn’t completely obvious, its still a shame to see innovation stifled by politics.
“Because there is so much uncertainty as to the timeline of the rules, everyone has to have really deep pockets to last out the time until the rules are finalized,” said Kevin McPartland, principal and director of fixed-income research at TABB Group.
A TABB study in April concluded that SEF consolidation would likely begin within two years of the Dodd-Frank rules being implemented, ultimately leaving about three or four SEFs per asset class.
This story was posted last week, and although its a bit odd to repost the story that quoted Kevin on the Street, I thought the author Katy Burne did a great job of explaining how the providers of CDS market data do what they do.
The decision to review alleged preferential treatment of certain vendors by major swap dealers is curious because regulators are already working to break up the clubby world of derivatives trading by steering over-the-counter instruments onto transparent platforms with near-real-time reporting, said Kevin McPartland, senior analyst at TABB Group, in a market commentary Tuesday.
“With huge OTC derivatives reform happening around the world that presumably will open up the market to more competition, why bring an antitrust suit now?” McPartland asked. “If an oligopoly really does exist, won’t derivatives reform end it anyway?”
FX swaps are exempt from new derivatives regulations in the US. Not really a surprise. This language was in an earlier version of Dodd-Frank and the geopolitical issues surrounding FX make it a very hard to thing to regulate by a single country. Not to mention the usual argument that FX functioned fine during the credit crisis.
The FX exemption is good for end users – but they’re still likely to end up posting collateral on rates and credit transactions. Yes there is an end user exemption, but dealers trading with them bilaterally will face higher capital requirements (as bilaterally trades will be seen as risky) the cost of which will be passed on to the end user client. All of that said, a lot is still in the regulators hands:
“Regulators still hold all the control and can still change things at will,” said Kevin McPartland, a derivatives market analyst at the Tabb Group.
Execution and clearing mandates for OTC derivative trades are still nearly a year a way by my estimates, but the Street is already getting ready. While Deutsche Bank and Bluemountain Capital executed CDS trades through Tradeweb and cleared via the CME and ICE, Barclays was busy rolling out its new electronic CDS trading product for clients. My comments in the article explain the status of the move to a post Dodd-Frank world:
“Currently there is little demand from clients to trade CDS or other swap products electronically; liquidity is still thin and brokers provide needed market color over the phone,” said Kevin McPartland, senior analyst at research firm TABB Group. “But availability today will leave everyone more comfortable when the big day comes.”