An Elegant Solution

Earlier this month, buy- and sell-side market professionals participated in an ISDA conference in New York on the future of the single-name credit default swaps (CDS) market. (Don’t worry if you missed it – a similar program is being held in London on December 1.)

The session was lively and well attended. The audience heard executives from firms such as General Electric, Blackrock, BlueMountain and Citadel discuss how and why they use CDS to hedge, manage and take risk. They heard that, despite the benefits, single-name CDS trading volumes continue to decline, for a variety of reasons. And they heard about potential solutions that could reinvigorate the market.

What were the key takeaways?

In the words of one panelist, single-name CDS are “an elegant solution” that belong in the portfolio of credit risk management tools. They enable bond investors to hedge the risk that an issuer may default. They also enable investors to diversify their portfolios by taking exposure via single-name CDS to companies that may not issue bonds often, or where physical bonds are difficult to source. In other words, they deliver considerable value to market participants. But despite that value, trading volumes are declining. Some of that decline is due to misperceptions (such as a belief that the use of single-name CDS caused the crisis – it didn’t). Some is due to regulatory uncertainty, some is the result of a benign default risk environment, and some results from the overall decline in structured finance.

One important trend that holds significant potential for the market’s renewal is the move towards central clearing of single-name CDS transactions. Clearing will free up capital on bank balance sheets and could bring much-needed liquidity to the market.

Unlike CDS index trading, there is no mandate to clear single-name CDS contracts. So despite the fact that hundreds of single names are clearable, the uptake for clearing has been relatively slow to date. The onset of margin requirements for non-cleared derivatives in 2016 and beyond will likely change that and incentivize the evolution to clearing.

But in the meantime, firms are considering several different ideas to reinvigorate the market. Some think regulators should mandate clearing of the more liquid single names. Others believe a tiered pricing structure may evolve for cleared and non-cleared single names. The merits of greater electronic trading are also being debated.

One upcoming change expected to occur in December is the move from a quarterly to a semiannual roll date for single-name contracts, which should improve efficiency in the market. It’s a step in the right direction.

We will no doubt see and hear additional ideas at our December conference in London. We at ISDA believe there is a future for the single-name CDS market, and we’re working in a number of ways to make sure that future is safe and efficient for all market participants.

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