Credit derivatives earned a bad name during the credit crisis and the European sovereign debt crises which followed, and probably deserved it too. Opaque and unfunded counterparty risk, credit event definitions that couldn’t keep up with bail-out mechanisms, and naked shorting of sovereign credit that could quickly close market access all caught regulators’ eyes.
But the ensuing regulatory clampdown has been a big benefit for the market, particularly the push to centrally clear more transactions. It has helped encourage potential users of credit derivatives back to the market, say bankers. “It’s fair to say that maybe three or four years ago we saw significant competitors withdrawing from credit derivatives or CDS on the basis that they were OTC instruments lacking clearing and other risk-mitigating factors,” says Benjamin Jacquard, joint global head of primary and credit at BNP Paribas.
“Now the picture is very different. People are coming back to CDS and index trading, and there are more single name credits that are cleared, including financials and sovereigns.”
Omar Ghalloudi , head of IG European single-name credit trading at Citi in London, says that with most inter-dealer trades now cleared, especially in the more common index names, regulators have a better grasp of the risks in the market as a whole, while big real money accounts are also keen to put trades through clearing houses. “All the right things are being done and the structure of the market has improved which should help it become more available to more people,” he says.
While single name volumes remain subdued, bankers take heart from the reaction whenever a narrative emerges — be it last year’s Volkswagen emissions scandal, Glencore’s debt levels when commodity prices plunged, or worries about French banks during the country’s presidential election. These stories, and others, were all accompanied by a surge in single name CDS trading — and it’s not a one-way market, either. “If there is a theme or a story there is always decent liquidity,” says Ghalloudi.
“I believe volumes will increase dramatically if/when the market turns — but we’re in a market at the moment that has done nothing but tighten and tighten with a huge stimulus from central banks,” he adds. “If this unwinds and the market goes wider everyone will be trading CDS.”
The CDS market has also benefited from a 2014 update to ISDA’s credit derivatives definitions. Market participants were concerned that bail-outs for financials and sovereigns, such as those for Portugal’s Novo Banco, were not triggering CDS payouts despite restructuring of the reference obligations.
“I don’t see material concerns on effectiveness of credit derivatives,” says Jacquard. “CDS is working well as an instrument, all historical amendments on the docs were welcome and are making for a well-functioning market. It is well coordinated by ISDA, is effective and is probably seen with a better opinion by regulators. The instrument had a bit of a bad reputation a few years ago and we are beyond that point which is good.”
The change in CDS definitions brought trading opportunities this year. Since CDS under both the 2003, and the new 2014, definitions could be traded on the same underlying, participants could trade the spread. That became important during the French election when some feared a potential victory for National Front leader Marine Le Pen could take the country out of the euro. Buying protection under 2014 definitions and selling protection under 2003 became known as the “ISDA trade”, and with US hedge funds to the fore, the spread between the two contracts moved out from 3bp to 38bp in April.
That showed that people were more comfortable under the new definitions — a sign that the market is working well, says Ghalloudi. “Those that might have felt wrongly positioned ahead of the French election as owning 2003 protection going into this were definitely buyers of 2014 protection,” he adds.
Even without this boost, though, dealers are more excited about activity in CDS index trading than in single names. A big part of that is down to the fall in idiosyncratic risks and the rise of macro risks amid central liquidity support for markets that has kept down company default rates while arguably making credit portfolios less liquid. “People in credit are effectively expressing macro views instead of idiosyncratic risk because of the involvement of central banks,” says Ghalloudi.
| The next 30 years | ||
While ISDA was celebrating the 30th birthday of its Master Agreement earlier this year (see box in Equity Derivatives), it is also busy planning for the future. The Master Agreement standardized derivatives trades for a generation but the ever-increasing demands of regulators and fast-evolving new technologies are presenting challenges for the next. The problem is that the back and front office systems that keep the market ticking are becoming overwhelmingly complex because fixes implemented by banks to deal with whatever is the next regulatory deadline get built on top of each other. ISDA wants to help standardise elements of the market infrastructure to reduce these inefficiencies. “We believe it is necessary to review the foundational standards on which the market operates in order to leverage some of the new technologies,” says Clive Ansell, head of market infrastructure and technology at ISDA in London. Those new technologies include distributed ledgers — most well known as the platform for Bitcoin, but, its supporters say, capable of supporting a derivatives “At the moment we’re still assessing what we can do to provide a foundational platform,” says Ansell. “Part of the challenge is that new technologies, such as distributed ledgers, are getting a lot of attention and there are a lot of proofs of concept around so if we wait around too long then we will have multiple solutions to the industry’s challenges all based on different standards.” Whether it succeeds or not ultimately comes down its members. “The success of the ISDA Master Agreement is proof of the success of an industry-led effort to create a standard,” says Ansell. “Instead of being in a situation where each operator of a distributed ledger has its own products, behaviours and descriptions, our members want consistency where appropriate.” |
Regular real money
In this environment, real money investors can both express macro views and hedge bond portfolios using the CDS indices, such as the Markit Main and Crossover indices. “It used to be really a hedge fund market but now we regularly see real money doing very large size, trades of perhaps several billions in one go,” says Ghalloudi. “The reason for that is the liquidity in cash has — at the least in the perception of some people — in the last five years worsened.”
The lack of bond liquidity is also helping push a resurgence of structured credit products and credit-linked notes. With spreads on most investment grade names several times lower than on the CDS, investors are clearly better off selling protection than buying bonds. Credit-linked notes allow retail investors to do that, albeit at the expense of liquidity risk.
The credit derivatives market is also taking cues from bond markets as it follows the trend to automation with trades taking place on platforms, where indices are already mostly traded. Regulation is the big driver, says Jacquard. “MIFiD 2 is on everyone’s mind and it involves many different pieces in terms of reporting and as well pre and post-trade transparency, and those things are only made possible if we progressively move away from voice to more automated or electronic execution.
“It does not mean that all flows will trade on platforms but voice trading with banks will move towards digitalisation, very much stimulated by MIFiD 2 requirements,” he adds.
For banks to do well in this market, distribution is key, he says. “You need to be able to provide liquidity to your clients and have a good capacity to recycle risk.
“The credit derivatives community is a small fraction of the overall credit community — there are a lot more people trading bonds than trading CDS — so it’s about making sure you connect to CDS participants and that you provide a good service and have a capacity to take risk.”
