Credit derivatives industry opinion is coalescing around a plan to limit single name CDS rolls to March and September, scrapping the June and December rolls. This would bring single name CDS more into line with the iTraxx and CDX credit indices, which roll just twice a year.
The aim behind this it to improve liquidity in single name trading, where market volume has fallen to around a third of the size it reached before the financial crisis. The logic is that halving the number of rolls should double the concentration of positions in the available contracts.
But it’s not an ideal solution for either hedge fund managers or bank dealers.
Market makers have made money from orchestrating the rolls, so giving up two of these is a sacrifice — although, whether sitting at one’s desk for the late December roll each year has been worth the extra money is a matter of debate.
But with previously active market makers — notably including Deutsche Bank in the second half of last year — stepping back from the single name business, another loss of revenue has got to be a consideration.
This comes on top of banks facing tougher capital charges that make it more expensive to hold inventory — a big factor in the market’s declining volumes.
For hedge funds, it must be harder to go long and short in a credit strategy if your only choice of CDS contract horizon is every six months rather than three. For a start, this leaves a larger degree of maturity mismatch and basis risk with the bonds that CDS reference.
But it’s long past the point where playing in single name long/short strategies was an easy feat. Most of the market’s fast money players have repaired to the only real centres of liquidity left in the game — namely iTraxx and CDX credit indices — and concentrated their energies on playing a good macro hand rather than picking credits.
So where is the push coming from? The clear signal is that it is coming from the big asset managers of the market, who have been almost unanimously long credit over recent years. They need the CDS market to hedge their bond positions and are desperate to maintain this possibility – being, as some traders point out, the only hedge left if the market blows up.
But more and more have also looked to the product in recent times as another way of going long a credit when they can’t get enough bonds in the primary market.
All of this suggests that even if single name CDS liquidity can be saved, it will remain a very different market from the long/short, intraday trading that was previously available to participants. Moving to two rolls from four is unlikely to bring that back.
For dynamic, two way markets to reappear there needs to be more fundamental change in the structure of the credit markets. Dealers need to be able to afford to hold more inventory — and, without a change in regulations (which is unlikely), that means buyside participants agreeing to pay up for single name contracts to be centrally cleared.
But while such proposals are also in discussion — led again by big buyside firms such as BlackRock — it is still questionable whether dealers will ever again be the source of two-way flows in the market that they once were.
Regulators might see this as a positive outcome — that CDS can be just the hedging product some have long wanted it to be, rather than a way of opportunistically shorting targeted names. And perhaps some believe it a good thing that CDS can't contribute much to overheating the bond market.
But leaving the product thus diminished creates its own problems — ones that look sure to come back to haunt those who have imposed the constraints.
If everyone can only find enough liquidity in the market to place their bets in one direction, then when the market’s direction changes — as it surely must at some point — then structural weakness will be hard wired in.
That is the problem of liquidity that, once life support for CDS has been enacted, remains to be addressed.
