The New York Fed Report, Hedging and Market-Making

Last week, derivatiViews commented on the New York Fed’s study on the CDS market. The study confirmed in many ways our own research and provided some important new data on market participants and their activity in the CDS market. We only wish we could see more OTC derivatives analyses from the New York Fed and other, well-regarded regulatory bodies. This week we address market-making and hedging, another topic covered in the report.

In Section X on Hedging in the New York Fed report, it was noted that when dealers executed large single-name CDS trades for customers, they did not engage in any offsetting trades on the same day 47% of the time. However, this was an average number and needed to be examined further. The report showed that for actively traded reference entities, same day hedging occurred 79% of the time. As might be expected for less liquid reference entities, there was less same day hedging – 55% of the time for less frequently traded entities and only 44% of the time for infrequently traded entities. And remember, there are only 10 trades a day in actively traded entities globally, four in less frequently traded entities and less than one trade per day in the infrequent entities.

Following this analysis of the market was a single statement in the Fed report:  “Our analysis seems to suggest that requiring same day reporting of CDS trading may not significantly disrupt same day hedging activity, since little such activity occurs in the same instrument.”

Some, though not all, commentators pounced on the statement, concluding same day reporting for large trades was the way to go. We were surprised at this. Indeed, we are still surprised. But one of ISDA’s responsibilities is education so we will educate.

For one, commentators may not have read the next sentence. It urged policymakers to gauge what impact greater post-trading transparency would have on dealers as dealers’ current hedging approach facilitates trading in the CDS market. Nor might they have understood the statement in the Executive Summary: “The low trade frequency of most CDS… combined with relatively large trade sizes highlights the important liquidity providing role of the market maker…”

So we thought we’d go back to square one and talk about market-making. We’ll start with a government bond desk. Say a client asks for a bid for an off-the-run 15-year Treasury bond. A bid is given and the dealer buys the bond. Does the dealer immediately try to sell the bond? Probably not. Suppose, just as it has purchased the 15-year bonds, it sells a 10-year Treasury note to another client and has thereby hedged its exposure to interest rate movements. The dealer may carry both the long and short positions on its balance sheet and will only unload the positions if it is concerned about curve risk, balance sheet usage or financing availability. Naturally, the dealer’s best outcome is to sell the 15-year bonds to one client and buy the 10-year notes back from another. But the willingness to hold positions explains why dealers carry billions of dollars of government bond inventory.

A similar process occurs for corporate bonds and CDS. Dealers have single name, industry and rating limits for credit product as well as aged inventory policies. Dealers are meant to facilitate client business. They have merchandise for sale – inventory purchased from clients – and add to that inventory when clients trade with them. It is no secret that, after providing liquidity to a client, a dealer may require a prolonged period to work out of the position.

Let’s look at an example of how this applies to a large CDS trade. Assume a dealer sells $20 million of protection on an infrequently traded reference entity, one of the 1,300 entities which the Fed has calculated trades less than once a day. What does it do? If the dealer immediately shows an interest in buying protection to brokers, other dealers will know it has a position. With less than one trade executed per day globally, the dealer needs to keep its position quiet. It may show a slight interest in one way or another to hedge part of the position but it must be careful or the market will trade against it. It may “hedge” its position through an index trade but it will try to work out of the position over time unless, of course, it does not like the credit. Then, it buys protection at whatever price makes sense to it.

What does this say about same-day reporting for large single-name CDS? It does not mean the full size and price details should be revealed immediately or even with a delay. Perhaps a good start is the TRACE system. TRACE requires disclosure of corporate bond trades within 15 minutes of execution but trade size need not be disclosed if it exceeds $1 million. The corporate bond market is more active although it trades in smaller sizes per trade. It respects the role of market-making and has protected it to ensure clients can buy and sell securities at reasonable prices. TRACE is not perfect but we hope reporting regulations for CDS markets will provide comparable protection of market-making.

We hope our little class has been useful and thank the New York Fed for their analysis. We know of more than one regulator that still owes the marketplace a cost-benefit analysis or two.