The shrinking corporate CDS market

The Dodd–Frank financial reform is killing the single name corporate CDS market. Liquidity in this market is drying up quickly. This is due mostly to dealers' inability to take positions when they make markets (Volcker Rule) and a cumbersome clearing process that will impose higher margin on corporate CDS for end-users (in some cases higher than the equivalent positions in corporate bonds via repo). In fact the business of basis trades - bonds vs. CDS - is no longer viable in many cases because of the margin requirements on both sides and no ability to offset.

The fact that dealers who clear CDS are not expecting this business to be profitable (see discussion) is not helping either. And single name CDS regulated by the SEC while indices such as CDX regulated by the CFTC adds to the uncertainty. At the same time margin and clearing rules differ materially among the clearinghouses (ICE, CME) and trades are not fungible between them (a trade cleared on the CME can not be offset with the opposite trade cleared via ICE). This uncertainty is adding to this decline in liquidity. The situation is so bad that an index of 100 CDS doesn't have enough liquid CDS for the index to be formed.

FT: - Indices that track the price of credit default swaps (CDS), contracts which act as insurance against a default on corporate bond payments, have become a popular way for banks and hedge funds to speculate on the creditworthiness of American companies and for bond fund managers to hedge risks in their portfolio.

But underlying CDS trading has shrivelled to such an extent that there are not enough actively traded names to make up a 100-company index.

This takes us back to the question of making the financial markets "safer". Not a single institution has ever failed due to a problem with corporate single name CDS. But banks and corporations do use this product to hedge all sorts of things - including receivables, counterparty exposure, reducing loan exposure to a single company, etc. It's not at all clear therefore how nearly eliminating this market through blunt regulation will be helpful for the financial system or the economy as a whole.

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Implementation issues continue to plague CDS clearing

The madness surrounding forced clearing of Credit Default Swap (CDS) continues to haunt market participants. The Dodd-Frank concept of "if it can be cleared, it must be cleared" is far easier said than done. Imposing a regulatory framework without understanding the implementation path can create all sorts of unintended consequences. And there is no shortage of implementation issues:

1. The details of the regulatory framework for CDS clearing continues to lack full detail. As the dual regulator (SEC and CFTC) discover things they didn't know about CDS, the framework and implementation become more complex.

2. The "cancel/correct" methodology will no longer apply. If one trades a bond for example and makes a mistake in booking the terms, the trade can be cancelled and corrected in a single transaction. With CDS a mistake would mean that a whole new offsetting trade would need to be booked and a new corrected trade would need to be booked separately, turning a single incorrect transaction into three.

3. The dealer involvement as a clearing agent involves significant capital usage because dealers would be required in effect to guarantee client solvency to the clearing house. That means if a fund transacts a CDS that is cleared on ICE, the fund's clearing agent bank would be on the hook if the fund were to fail. Therefore the clearing agent has to commit capital for transactions they are not a party to. This makes the CDS clearing agent business potentially  unprofitable. It is therefore unclear how committed the dealers are to this business in the long term. Which in turn means that clients will need to set up multiple clearing bank relationships to protect themselves from suddenly losing their clearing bank and being unable to execute.  Setting up these relationships tends to be expensive and time consuming.

4. But having multiple clearing banks is not a great outcome either because if a client clears a CDS buy with one dealer and the same CDS sell with another dealer, the two can not be offset even if the positions are held on the same clearing house (ICE or CME).

5. The two clearing houses ICE and CME contracts are not fungible. If a client clears a buy CDS on ICE and a sell CDS on CME, the two can not be offset and the clearing house must be specified at the time of the transaction. Also because of different capital requirements by the clearing houses (#3 above), CDS pricing for clearing on ICE or CME may actually be different. Thus a client would need to maneuver among multiple clearing banks and two clearing houses without the ability to easily move/offset among the platforms.

6. Basis trades are still a problem.  If a fund is short a bond and a CDS in the same credit, the majority of risk is offset.  However the fund will have to post margin on the short bond to their prime broker and margin on the CDS to the clearing house with no opportunity for any offset.

7. The margin requirements on ICE and the CME are completely different. The biggest difference in margin methodology has to do with the so called "jump to default" (JTD). The clearing houses are trying to put protections in place to address not just movements in spread, but also a sudden default. It is effectively a "concentration" charge that drops off as the portfolio becomes diversified as shown in the CME chart below.

If a fund sells protection on a single name CDS (as opposed to an index), and that single trade is all they have on CME, the margin they would need to post becomes enormous relative to what is charged by ICE who has a much more realistic margin charge.  Posting a margin of 80% on a CDS is at least three times what one would post on a corporate bond, even though the risk associated with a corporate CDS and a corporate bond is very similar. Therefore unless one has a diversified portfolio of CDS, clearing via the CME for one or two positions would become prohibitive.  This tremendous difference in margin requirements is yet another issue plaguing CDS clearing implementation in the US.

The documents below describe in some detail the risk/margin methodologies of the two clearing houses ICE and CME.

ICE Risk Presentation


CME CDS Risk Management - Margin

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ICE is asking CFTC to allow CDX and CDS in one account

The CFTC is seeking industry comments on the ICE Clear Credit request for "Commingling" and "Portfolio Margining". As a bit of background ICE (the Intercontinental Exchange) is preparing a platform to clear credit default swaps (ICE would become a "clearinghouse"). It's a slow and tedious process because so many regulatory and "plumbing" (process/technology) issues need to be worked out for CDS.

In their infinite wisdom US politicians have split the regulatory oversight over CDS clearing. Index CDS (such as CDX) are to be regulated by the CFTC, while the SEC is to regulate "single-name" CDS (for example CDS protection on Ford). The rationale here is that the SEC regulates public companies - therefore "single names", while the CFTC deals with futures, many of which are indices. It is quite common for industry participants to have both types in the same portfolio, for example selling protection on one or more single names while buying protection on the index.

Of course neither the politicians nor the two regulators have fully thought this out. After all the futures industry lobby that has been pushing for CDS clearing does not fully understand how CDS is used in practice. Realizing the problem, ICE is trying to get permission to do the following:

1. Keep both single-name and index CDS in a single customer account (separate accounts for different customers of course) in order to allow clients offset gains on one with losses on the other. This is particularly helpful if the strategy is some sort of a spread trade or one type is used to hedge the other.

2. Allow portfolio based margining in this single account. That is if the long and the short CDS have significant risk offsets (short single name CDS vs. long CDX for example), the margin requirement would be reduced. That is the lower the risk, the lower the margin. Obviously there would be the "jump to default" margin charge for each position that can't be "hedged", but portfolio diversification would help reduce that charge.

This is a sensible way to structure CDS clearing and should be permitted. If the CFTC does not accept this request, it will put a significant damper on CDS liquidity, making it that much harder for institutions to hedge credit portfolios and reduce risk.
ICE Exec Summary Portfolio Margining

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SNAC on this: the standardization of single name CDS

A number of Sober Look readers have asked about the structure of single name credit default swaps that would be settled via a clearing house. Here is some background.

The cleaing house for CDS that has gotten the most traction is operated by ICE (the Intercontinental Exchange). CME is trying to get in the game as well. So far however only some index credit derivatives have been settled on ICE, while single name CDS settlement is still in the works.

As with any standardized contract, one tries to limit the number of variables. With single name CDS, the contractual variables are usually maturity, spread, points up front (upfront premium), and settlement mechanics. In the past all of these could vary. That created problems for active traders.

If you buy 100 futures contracts and sell 100 of the same contracts later, you are flat and have no further obligations. However if you buy and sell the same notional CDS with slightly different maturities (even by a few days) and/or slightly different spread (which is almost always the case), you now have two different contracts. And until they mature or get unwound (which is expensive), you will have to manage two different contracts. So if you actively trade these, you may end up with thousands of positions that may be neutral (buys and sells with the same amounts), but the contracts are still outstanding. That's why when the media quotes "trillions" of outstanding CDS contracts, a large part of these are long and short of very similar contracts that can not be netted. You could be flat and have locked-in gains on a bunch of CDS, but your trades were with Lehman, you've lost the bulk of these gains. That's where a clearing house becomes helpful.

The idea is to standardize maturity dates, spread, and settlement mechanics, while leaving points upfront as a variable. Settlement in the past gave one a choice of physical delivery (the protection buyer could deliver the defaulted security and get paid par for it) or an auction settlement. A corporate restructuring could be considered a credit event under some contracts. There were other variations as well. All of that has been standardized to auction settlement, with credit events now decided by a committee (which becomes binding under the new documents.)

Under the new standard, the maturity dates will be only March 20th, June 20th, September 20th, or December 20th. The spread will be either 100 or 500 basis points (100 bp for investment grade names and 500 bp for non-investment grade). Thus the spread will be constant and only points upfront will fluctuate. Now if you buy protection and sell it back, you will be doing it with the same contract (same maturity and spread), and the only difference is between the points upfront you paid when you bought protection and the points you received when you got out (which will be your P&L). And given that you will face ICE on both the buy and the sell, your contract will be netted out and you will have no remaining obligations.

The coupon (spread) accrual on these contracts will be handled the same way it is for bonds (and most index credit derivatives).

These standard contracts are sometimes called “SNAC” transactions - Standard North American Credit ISDA docs. Converting existing non-standard contracts to SNAC unfortunately can not be accomplished without unwinding existing trades, which could get costly. These non-standard contracts will also quickly become illiquid. The goal is to have SNAC compliance on the bulk of CDS transactions going forward, whether or not they are settled via a clearing house.

The document below from DTCC(www.dtcc.com) discusses the detail of the clearing house standardization.