Thursday, December 17, 2009

Secrets strengthen case for CDS exchange

Original posted in the Financial Times by Gillian Tett:

Until recently, not many western politicians – let alone those in Greece – knew much about sovereign credit default swaps. Even fewer cared.

But I suspect that is about to change. This year the CDS spreads on sovereign debt have swung sharply, as investors have turned to these products to hedge themselves against the danger of a government default (or quasi default). In the case of Greece, for example, the spread is currently about 240 basis points, compared with 5bp three years ago.

And since the CDS market is apt to be a leading indicator for other markets (just look, again, at the recent experience of Greece), the movement of spreads is starting to grab attention from investors and politicians alike.

To many CDS fans, this is gratifying. After all, this rising focus on CDS supports the idea that these products are a useful part of the modern financial toolkit.

However, there could also be a sting in the tail for CDS lovers. As the level of attention grows, the level of regulatory and political scrutiny is likely to rise too. And if politicians do start paying more attention to the world of sovereign CDS – as they are likely to do if, say, more market turmoil erupts – there is a good chance that they could find things in this market that leave them perturbed.

After all, one dirty secret of the sector is that trading volumes in the market are apt to be low, even in instruments that attract high attention (such as Greece or Dubai). Worse still, nobody really knows exactly how low volumes are (or not), because this is an over-the-counter market, conducted away from any exchange.

Thus even when spreads swing wildly on a sovereign name, it is hard to know whether that has arisen just because a big hedge fund has tried to move prices by conducting a huge trade – or whether there is truly a liquid market with sellers and buyers. Indeed, it is pretty tough for non-bankers even to get intraday prices for sovereign CDS (and though end-of-day quotes have recently become publicly available, these vary between data providers).

The pattern of investor demand also seems uneven. In the past year, plenty of investors have been buying protection against the chance of sovereign default. However, it appears that the main sellers of this protection are banks. That creates the perverse situation that (as the European Central Bank recently observed) European banks are now net sellers of insurance against the chance of their own governments going into default – even though those same banks are implicitly backed by those governments.

None of these problems, of course, is entirely unique to sovereign CDS; many other immature OTC markets are also pretty illiquid and opaque (and since sovereign CDS is just a few years old, it is still immature.) But what makes sovereign CDS so fascinating is politics. If prices swing wildly in opaque OTC equity derivatives products – or even CDS linked to small companies – politicians are unlikely to care.

However, if sovereign CDS start gyrating, and affecting government debt costs, that could create more controversy. Indeed, it already has: when the government of Iceland tipped into crisis last year, it was quick to claim that hedge funds were manipulating the price of Icelandic CDS.

Is there anything banks can do about this? Personally, I think the situation strengthens the case for moving some core corporate CDS indices on to an exchange, along with some sovereign CDS. After all – as one of the savviest Wall Street players recently pointed out to me – if you look at the other big four asset classes in the financial world today (namely equities, rates, foreign exchange and commodities) it is notable that all of those have transparent, credible benchmarks, to act as a “core”, around which bespoke, more opaque, products can be built.

Credit markets, however, have developed without this, because although corporate indices such as the iTraxx are liquid, they are not as publicly credible and transparent as, say, the S&P 500, the gold price or dollar-yen rate. Now putting trading on an exchange is certainly not the only way to garner more investor credibility. But it is the easiest way to create a stronger “core” and protect the sector from political sniping too. And even if a small core of products were placed on an exchange, banks could still create bespoke products too, referencing that core.

Will this happen? Don’t hold your breath. Most large banks strongly oppose the idea of exchange trading for CDS; instead, they hope that improving the OTC infrastructure, by improving clearing platforms, will be enough.

But this seems a missed opportunity. In the long run, I believe that CDS can play a useful role in the sovereign and credit debt markets alike; but right now, the market badly needs to mature. If not, the next western fiscal dramas could soon generate more publicity for sovereign CDS – but not in a beneficial way.

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