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.