CDS market liquidity
Tuesday, May 19, 2009 at 02:57PM “In general, the liquidity of a credit derivative asset increases when it is showing signs of financial stress in combination with a significant amount of debt...” - Mr. Fitch, 05.05.09
We want to bring to your attention this nifty little credit market research report courtesy of Fitch, on CDS market liquidity. We recommend you register a free account with Fitch in order to gain access to some of their research reports, but we have taken the liberty of placing this document here, and in the Education Materials section of our prison.
In general, market liquidity has been increasing strongly so far this year. Fitch claims this heightened liquidity is due to the benefits of “standardized” systems as they are being brought onto the clearing house, approaching what they call the “CDS Big Bang”. We find this name hysterical, since it is quite appropriate for what is going to happen. Though Fitch tries really hard to make it seem as though liquidity is a good thing in general, make no mistake about it, heightened CDS liquidity is a direct indicator of heightened credit risk.
We can say this for a variety of reasons, and the report provides much evidence. For starters, as we saw in A Detailed look at the Derivative market, it is important to remember that the entire CDS market is dominated by 5 large banks, you know who they are. The fact that they are mainly dealing only with each other, the notion of liquidity is fundamentally changed from its usual definition. The efficiencies brought about by the participation of a very large number of agents that is normally the connotation given to market “liquidity”, are absent. Instead, in the CDS market, heightened liquidity only means the 5 banks are trading more often amongst each other. Remember this as you read the report. Since these are credit protection instruments, one could also infer that much more protection is demanded against different types of credit. Either CDSs are hedging costs, as reader CM0101 has explained, or they are protection against underlying credit the buyer of protection holds, or they are speculative. In all cases, it would make sense to us that heavy CDS trading volume (ie, more liquidity) amongst these 5 banks, the smartest of the smart money, would mean that underlying credit risk has increased, or at least perceived to be increased.
The report provides ample evidence that heightened liquidity is a indicator of heightened credit risk. We will report on the main points, and we will underline all supporting evidence. In general Fitch developed a liquidity score, which they explain in the report; the higher the liquidity, the lower the score.
The US liquidity continues to rise, declining to 9.70 nearing its all-time low of 5.57, the day following Lehman’s bankruptcy.
The liquidity of Mexico significantly increased on 04.24.09, following the outbreak of swine flu.
In the Americas, the financial sector continues to dominate the liquidity in the US Market. General Electric remains in the top spot, as we saw in The Top 100 riskiest borrowers in the World.
In Europe, the dominance of telecom companies in the liquidity (ie credit risk) arena appears to be receding with the automotive industry becoming more prominent.
In Asia, Korean names dominate liquidity tables, with Samsung Electronics, Woori Bank and Korean Development Bank at the top. This negative view of Korean credit risk aligns well with what we saw in Sovereign Credit Risk.
That’s it, nice little informative report Mr. Fitch.
May your capital be safe and your investments prosperous,
MAAA
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Reader Comments (7)
If I understand this correctly ( a large if) then we have five banks trading amongst themselves for the most part (is that correct). Are some of these banks long on interest rates and some short? Or alternately are they trading each other the same type of contracts. The second option is not logical in an economic sense but with the govt bailout people all the time it might actually make sense if done in the right way. However given the current political climate it would be pretty foolish for the banks to attempt this.
Third the banks playing hot potato selling the contracts on to each other. This seems somewhat probable.
If you look at the total outstanding notional in A detailed look at derivative markets for commercial banks you'll see that the top 5 own about $16tr. The total amount of credit derivatives outstanding, at about $26tr, some back of the envelope math reveals 5 banks control close to 62% of the whole CDS market. So, to a large extent, they are just effectively dealing with each other. As for interest rates, I'll say that the purview of this post is simply credit. I personally don't know how to estimate the proportion of banks that are long or short interest rates. As for CDS however, they are trading the same type of contract to begin with. There are some standardized stipulations by the ISDA. I believe that they are in fact, playing hot potato with each other on the underlying credits. What people are not widely aware of is that the banks make most money through bid-ask spreads. Perhaps reader CM0101 cares to enlighten us. I intend to do a post soon about the so-called "CDS Big-Bang", and lay out what I believe will happen with credit losses once this event comes about.
As for interest rate derivs, what we would like to know is how are they cleared and who clears those trades and who are the main players. We will do our homework, but some help would be appreciated.
I only brought up interest rates because many of the derivative contracts are based on them and therefore I assume that for the most part this is what the banks are concerned about when the look to buy a CDS contract. The problematic element to me is that these entities being the smartest of the smart as you say must know that throwing around more CDS contracts simply redistributes risk amongst themselves and does not eliminate it. If you only have five banks and bank A buys a CDS to hedge a contract with bank B from bank C bank A must realize that it has only reduced its risk to the degree that bank C is likely to survive if bank B fails. If my assessment of this situation is accurate it seems irrational and worryingly so.
I completely agree with you on its irrationality. As you said once also, and I believe as well, is that if one of the banks fails, then they all fail. As was seen in the Comptroller of the Currency report, the fact that netting benefits are so large imply that sometimes bank A sells and buys protection simultaneously with Bank B. For that reason, and the fact that the entire market is dominated by so few entities, the market itself is one and the same as the banks. It all goes, or none of it goes (unless of course there is yet another massive and unprecendent type of bailout). It does seem irrational behavior, since by increasing the size of it so dramatically banks are heightening systemic risk and hence their own risk. That however, could be more easily understood if the KNEW the government stood ready to back them up (which they are).
My understanding is that CDSs are written in order to protect against credit risk for a particular underlying. For that reason, there is a clause in the ISDA contract which gives precise definitions of an "event of default", which then triggers the exchange of the underlying credit with cash at par, though most settlements are cash. Could you please explain how the interest rate risk comes into a CDS? Because it seems to me that IR derivatives are used exclusively for that purpose. I might be wrong, if so please correct me.
Apologies but do not understand the questions. A CDS traders job involves buying and selling swaps in a particular fixed income sector, he knows what Beta he wants his book. In other words if he has a view (or can take a view) on a particular credit he might sell more swaps rather than buying and takes on the risk with him. Most of the times they are not allowed to take risk and their main job is to make sure they are risk neutral however things sometime can get out of hand in high volume names. As our host MAAA pointed out the way they earn a paycheck is through the bid ask spread plus mark-up to the client.
Thanks for the explanation CM0101. What I am thinking is that a trader can take a position on say an interest rate derivative for examples and then hedge it fully locking in his profit. Then he can buy a CDS to hedge against the credit risk of his hedge. Thus his position appears to be delta neutral when in fact it is probably not.
I see Discipulus. I think its best to step back and view the IR market for what it is. Think of the IR market as the Libor market but with many more different nuances that can be tailor made for a specific interest rate need. The IR market is NOT used to speculate, again the reason is that you have the most liquid market to use if you want to speculate on rates (govie market which is comprised of government debt such as Treasuries). So long story short a trader CAN NOT take a position on rates via the IR market bcs if so he would be a prop trader. Most traders are NOT allowed to take any sort of position unless there is a very good reason for it and it better be a good reason or youll get canned. Traders that take positions are almost 100% proprietary traders at big banks, desk traders (which is what you are referring to) are nothing more than glorified salespeople. They are 100% net sellers and hate the fact they have to make you a market just so you know. The IR market has c/p risk as we found out recently but we know every country in this world will stand behind their financial system (i.e. eliminate c/p risk)whatever the cost. Some say this is at the expense of the middle class, I am not that savvy to understand that link, but I say its at the expense of comodity prices until someone somewhere will say No Mas. Don't forget that commodities behave just like people.