Wednesday, May 12, 2010

Odd trends in CDS liquidity

Original posted on FT Alphaville by Joseph Cotterill:

CDS liquidity is suddenly on the rise somewhere in developed markets, Fitch said on Wednesday, using its, er, unique liquidity scoring.

(The lower Fitch’s score, the more liquid contracts on a given reference entity are, which, according to Fitch, indicates greater uncertainty over credit risk.)

However, Fitch’s findings are perhaps not what you think, if you’ve been following Europe’s sovereign debt crisis.

Sovereign CDS remains significantly liquid in developed markets, as you can see from the red line hugging the bottom of Fitch’s chart below — but it has recently become rather less runny (click to enlarge):

Uncertainty in the run up to the weekend’s European rescue package is still to be factored in, no doubt, but it’s still a bit odd. A whiff of regulatory risk is closing positions, perhaps? We can’t be sure.

Even so, take a look at this sector-level CDS liquidity chart (click to enlarge):

Financials pop out of the picture. As for explanation, here’s Fitch, emphasis FT Alphaville’s:

The Sector Liquidity chart shows the average CDS liquidity for the 25 most‐liquid reference entities within each sector. Remembering that the lower the liquidity score, the more liquid the contract, CDS on financial institutions and sovereigns appear to be trading with the most liquidity. Digging deeper, it is apparent that of the 25 most liquid financials, 23 are domiciled in North America with the remaining two in Europe. The Security and Exchange Commission’s lawsuit against Goldman Sachs & Co. in addition to ongoing debates in the Senate over the proposed financial regulations bill, have contributed to renewed uncertainty…

Well, there are a fair few complicated legal risks facing Goldman. Banks have had a rally in CDS tightening over the past few days, on the other hand. For example, Markit’s Senior Financials Index dropped -15bps, to 123bps, on Wednesday. (Goldman is still elevated at 184bps).

Still, who are Fitch’s most CDS-liquid European banks? As the agency says:

CDS written on Banco Santander continue to trade with more liquidity than any other bank in the region, followed by Lloyds TSB Bank plc of the UK and Bank VTB (JSC) of Russia.

Santander CDS has also tightened like lightning since the weekend’s eurozone bailout, reaching 127 bps on Wednesday from 157bps the day before, Markit said.

Very odd bedfellows, though.

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