CDS Unveiled: The NY Fed’s CDS Report

The Federal Reserve Bank of New York issued a paper on the CDS market this week that was quite thorough and professional. We found it interesting on several fronts – so much so that we’ll devote two derivatiViews posts to it. Today’s will focus on market size and we’ll agree with most of what the report reveals. We’ll try to show how market-making works and how dealers offset risk as well as the importance of reporting delays or incomplete trade reporting for large trades. (Readers should also know that our press colleagues have discussed briefly the media reaction to the report in our media.comment blog.)

The Fed paper examines three aspects of CDS market size: the frequency of transactions, the average size of transactions and finally the number of participants. We will focus on the single-name CDS market as that has clear analogies in the corporate bond market and it will keep our story short and sweet.

Regarding frequency of transactions, the report confirms what ISDA and other commentators have often said in the past. Single-name CDS do not trade very often. In fact, the report shows a total of 3,000 single-name trades a day – both corporate and sovereigns. This global volume compares with volumes in the US corporate bond market alone (which excludes the large Eurobond market) that are five or more times as large. Over a 12-hour trading day, single-name CDS trade only 250 per hour. Apparently, CDS traders do not do very much trading.

But that’s not all. The report divides the 1,554 reference entities that traded during the three-month study period into three categories: the top 48 “actively traded” reference entities; the next 219 “less actively traded entities; and the last 1,287 “infrequently traded” entities. How much do each of these entities trade each day? The answer is: not much. The actively traded names trade only 10 times on average. Less actively traded entities trade only four times per day while the largest category by far, the infrequently traded entities, trade on average less than one time per day. Each of these figures confirms another fact about the CDS market. Not only is the market small in the aggregate but it is small with respect to every single name as well.

The report also contains useful information about transaction size. In the single-name market, the average size trade for corporate CDS denominated in US dollars is $6.7 million and for euro-denominated CDS it’s €5.9 million. Sovereign average size is larger – $16.7 million and €12.5 million. Five percent of US dollar corporate trades are $20 million or higher while the same figure for sovereign CDS is $50 million and €50 million. We do not have comparable figures for the US corporate bond market but knowledgeable participants have assured us $20 million trades do not make up 5% of the market. These figures point out what other studies have shown. The CDS market is a wholesale market designed for large players.

Finally, the last characteristic of market size is the number of participants. Here we disagree with some of the comments in the report, but are grateful for the data the NY Fed compiled. The report finds a “broad level of participation in the CDS markets” and cites as evidence the fact that there are 50 to 100 unique market participants trading daily in single-name CDS. We recognize the report uses the word “broad” in a number of ways, but how can 50 to 100 participants be categorized as broad? In the entire three-month trading period, there were only 993 unique market participants and this includes players in the credit indices market. Changing terminology slightly, the report states that 500 participants trade corporate CDS at least once a month. Forgive us for scratching our head when these levels of participation are described as “broad.”

Taken together, the market data in the report confirm a description of the CDS market we have long espoused. CDS buyers and sellers are few in number, execute a small number of trades, and prefer those trades to be larger-sized transactions. The CDS market requires strong market-making. Participants use the market because it works and offers the size, price and certainty of execution the cash markets cannot provide. We will pick this up next week and discuss market-making.

One A-Maize-ing Use of Derivatives

Our focus in many of our derivatiViews to date has been on the effects, often unintended, of global regulatory efforts on derivatives markets. Every now and then, however, it’s refreshing to read about the continuing innovation and targeted solutions that have been, and we are confident will continue to be, a hallmark of the derivatives business.

A case in point is the solution that the World Bank is delivering through a program in Malawi. The World Bank, of course, was party to what is widely considered to be the first swap three decades ago. They have continued to be an active user of derivatives to manage their significant interest rate and currency exposures. What is perhaps less widely known is that, in connection with their extensive programs in developing countries, they are providing innovative solutions to chronic problems faced by those countries’ economies.

Weather derivatives have been around for over a decade. The World Bank’s structuring of a weather risk management transaction in Malawi delivers a custom-tailored solution to address fluctuations in rainfall and, therefore, production of maize, a critical part of the Malawi economy where agriculture contributes 38 percent of GDP.

In order to provide the protection desired, an index was constructed, the Malawi Maize Index, that reflects the typical yield in maize production per hectare. The index consists of several fixed parameters and one variable factor, precipitation. When rainfall falls below a certain level, the index provides a projection of the loss in maize production, with compensation to Malawi for the shortfall.

As with many derivatives, the structure responds to a specific need with a carefully developed solution. Its effectiveness also relies on access to reliable historical data so that models of maize production can be projected with a reasonable degree of accuracy. In this case the Malawi government has been using a production model since 1992, so almost two decades of information was factored in.

The World Bank manages its exposure by entering into an offsetting arrangement with a market counterparty, in this case Swiss Re, which in turn can choose to hold onto that risk or similarly hedge its exposure.

Cost was an important consideration for Malawi, which paid a premium for this option. This may be a small transaction in a tiny corner of the global derivatives world, but it is important to keep these cost considerations in mind. Users of derivatives will ultimately bear the cost of regulatory reform through higher prices for the products they use. For some that may mean choosing not to manage a risk, leaving themselves exposed to the underlying risks they face in their business or, as in this case, for an entire country’s economy.

Rain and maize are, at some level, no different from rates and credit. For the derivatives business, they are variations on the theme of understanding your risks and being innovative in managing them. Let’s not lose sight of that essential truth.

Asking the Hard Questions, Part II

Yesterday, ISDA held its Annual New York Regional Conference, which we previewed for you in Monday’s derivatiViews. Commissioner Scott O’Malia of the US Commodity Futures Trading Commission provided the keynote address to the 250 members in attendance. ISDA Chairman Stephen O’Connor discussed the important challenges facing the OTC derivatives markets and ISDA’s approach to addressing them. It was, by all accounts, another successful ISDA event.

A consistent theme throughout the day was the need to assess whether the current pace and direction of regulatory reform in the US is taking the derivatives markets closer to the overriding goal of systemic risk reduction. ISDA supports this important goal, as espoused by the G20, and the industry’s progress in clearing, compression and trade repositories underscores its commitment to making OTC derivatives markets safer and more efficient.

Connie Voldstad’s remarks, which opened the event, sounded this theme. He noted that as the regulatory reform process unfolds and rules are implemented, we will know much more about what the reform initiatives will actually entail and what they will cost. As the industry puts these initiatives in place, this knowledge may result in the emergence of alternatives that more effectively reduce systemic risk.

He urged the industry and policymakers to be flexible in finding, assessing and adopting the best solutions and to avoid locking into one path that may ultimately prove less constructive than others. A case in point: given the costs and benefits of clearing vs. collateralization of non-dealer OTC derivatives transactions, it might be possible to mitigate their risk much more simply and effectively through collateralization provided it is completely standardized and overseen by an independent third party. This party could then affirm that all exposures are properly collateralized and provide counterparty exposure information to regulators. Concrete proposals on ideas such as this might come in 2012 or several years in the future.

Unfortunately, one press report coming out of the conference misconstrued Connie’s remarks to create a misleading and distortive headline that was completely out of context. The text of the speech is here so readers can access it directly.

One additional note about the conference: we were very pleased to have Professor Craig Pirrong join us to moderate a panel on clearing. Professor Pirrong, who is one of the foremost authorities on the subject, will also participate in our London conference next week. He’s chairing a panel on “Clearing: Challenges to Achieving Its Risk Reduction Potential.” Bob Pickel will address the conference in the morning and Connie will moderate a panel on “Front Office Visions of the Derivatives Future.” Other sessions will cover current regulatory, trading infrastructure and legal issues and developments.

We hope to see you there.

Comments on this and all derivatiViews posts are welcome. Those who wish not to be identified can post their name as “Anonymous” when submitting their thoughts. Email addresses are not published with any comment. 

Asking the Hard Questions

This week we begin our series of annual update conferences in New York, followed by London next week and Sydney, Hong Kong and Tokyo in October. Here in New York we are honored to have CFTC Commissioner Scott O’Malia providing a keynote address. We will also be joined by University of Houston Professor Craig Pirrong, who will moderate a panel on clearing. He will do the same in London.

Commissioner O’Malia and Professor Pirrong consistently do what we aim to do with derivatiViews: ask the hard questions about the changes that are being put in place for the derivatives business.

When considering the pros and cons of any proposed rule before the Commission,  Commissioner O’Malia brings a consistent framework to his analysis:  What are the costs of the rule? What are its benefits? What will the effects of the rule be on the availability, liquidity and costs of these important risk management tools? And a favorite topic for him: does the CFTC have the resources, particularly technology, to carry out its mandate effectively? All excellent questions.

Even when a rule is final, Commissioner O’Malia continues to apply these benchmarks to his work. For example, the CFTC recently issued a final rule on the criteria for mandating clearing, which will be intertwined with the mandate for execution on swap execution facilities ( SEFs). He reached out to ISDA and others in the industry for input on a host of issues arising out of the rule. We provided that input to him last week.

Through his blog, Streetwise Professor, Professor Pirrong has regularly asked serious questions about the course of regulatory reform, particularly in the US but also globally. His study published earlier this year, The Economics of Central Clearing: Theory and Practice, has been downloaded thousands of times from the ISDA website, quickly establishing itself as the go-to guide for what clearing can and cannot do. The issues raised in that study will provide the framework for his panel discussions this week and next.

When it comes to Dodd-Frank the clearing mandate is not the law’s most problematic provision, according to Professor Pirrong. He reserves that position for the SEF mandate, although his description is, shall we say, a bit stronger. It so happens that we are also looking into the costs and benefits of mandating that whole categories of OTC derivatives be executed in one way. We plan to produce that analysis shortly and will no doubt highlight our conclusions in a future derivatiViews. We support the greater use of electronic execution, but believe that an execution mandate only works to inhibit customer choice. Unfortunately, the latest reports from Europe indicate that policymakers there are still considering a similar mandate.

We look forward to Commissioner O’Malia, his fellow Commissioners and Professor Pirrong continuing to ask the hard questions, and we hope that our efforts in derivatiViews will also add to the debate.

Is There a Better Way?

ISDA has published studies recently that give us a better understanding of the functioning of the OTC derivatives market leading up to and during the financial crisis. A recent paper on the US banking system found relatively modest losses arising out of counterparty defaults of plain vanilla derivatives.

The paper also found that mandatory clearing called for by the Dodd-Frank Act would increase variation margin by $30 to $50 billion among US banks, again a relatively small sum in a $14 trillion economy. Clearing, of course, requires payment of initial margin as well. The Office of the Comptroller of the Currency (OCC) estimated in a paper that initial margin requirements could total over $2 trillion globally under certain circumstances, a truly staggering sum. Other estimates of initial margin start at the hundreds of billions of dollars of new collateral needed. What this means is that the new regulations may require over a trillion dollars in initial margining to protect against incremental exposures whose current mark-to-market value is perhaps $50 billion. We have not seen any cost benefit analysis of clearing and initial margins that justifies this approach.

How did we get here? During the financial crisis, global regulators were unsure how the market would handle defaults of major participants. OTC derivatives contracts amounted to hundreds of trillions of dollars of notional amounts with thousands of participants. It was not clear how many were subject to collateral requirements nor was there uniformity in collateral practices. Some had initial margin and daily margining. Others only had variation margin after a threshold exposure was reached. Furthermore, regulators did not know if another mortgage problem existed through a single entity such as AIG FP or through widespread risk-taking by many participants. Out of this grew the requirement for mandatory clearing and trade reporting.

The requirement is leading to a host of clearinghouses around the world. As they are created and used, they reduce the benefits of bilateral netting (which we discussed in a previous derivatiViews). In some cases, the benefits of risk reduction from clearing will be exceeded by the additional risk created by losing netting benefits. That’s even before considering the costs of clearing.

As noted, the clearing requirement was not subject to analysis nor were other alternatives. ISDA would like comments from readers on the following approach:

  • First, we do agree that interdealer contracts for standardized products should be cleared. For very active participants, initial margining is quite efficient.
  • Second, all financial entities (subject to de minimis exceptions) should have two-way collateral arrangements for variation margin. This would include AIG and all the monolines that wrote CDS on mortgage CDOs. These arrangements should be completely standardized – no exposure thresholds and margin posted daily. The collateral process could be overseen by an independent third party.
  • Third, the parties can decide for themselves the amount and extent of initial margin required.
  • Finally, trade and counterparty reporting should be put in place to reveal risks taken both by individual counterparties as well as by many participants together.

Our proposal will not eliminate losses due to the absence of initial margin. But it will reduce the excess costs of initial margins for creditworthy counterparties. And it will also give regulators the transparency they need. With initial margin running anywhere from the hundreds of billions to the OCC’s estimate of $2 trillion or more, perhaps the benefits of our proposal exceed the alternative “one size fits all” approach that we are unfortunately moving toward.