Traders in credit default swaps have been in the cross-hairs of regulators ever since a single CDS bet was blamed for sparking a one-day rout in Deutsche Bank AG’s shares back in March.
(Bloomberg) — Traders in credit default swaps have been in the cross-hairs of regulators ever since a single CDS bet was blamed for sparking a one-day rout in Deutsche Bank AG’s shares back in March.
Andrea Enria, Europe’s chief banking supervisor, was on the warpath again this week, telling lawmakers that the market for these derivatives — a measure of the cost of insuring a bank’s debt — is “very shallow and illiquid,” making it too easy to create wider financial havoc.
The problem is, people who trade them don’t agree. “Deutsche Bank’s CDS is very liquid,” says Josef Pschorn, a portfolio manager at Xaia Investment.
As regulators try to bring this complex and systemically critical part of the $10 trillion global swaps market under control, this lack of consensus on how it actually works shows how hard that task will be.
Enria has reason to worry. In the immediate aftermath of Credit Suisse Group AG’s demise in late March, traders used Deutsche Bank’s swaps to speculate on Germany’s biggest lender, pushing up the price of its debt insurance and spooking bond and equity investors.
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The panic was short-lived, but regulators were duly alarmed at a time when similar momentum trades were triggering mass deposit withdrawals at US regional banks. They identified a single $5.4 million CDS trade as the prime driver of the Deutsche Bank stock rout.
However, one senior credit specialist at a top Wall Street firm, who wanted to remain anonymous discussing private market matters, says trading in Deutsche Bank’s swaps soared after the emergency sale of Credit Suisse. The lender’s CDS instruments are among the most easily tradeable of their type, people who buy and sell them say.
In fairness to regulators, the single swaps trade they blame for the turmoil was tied to the German bank’s junior debt, a part of the market that’s less liquid than the CDS linked to senior borrowing. Nevertheless, prices surged across both the senior and subordinate CDS instruments.
Data from ICE shows the volume of Deutsche Bank CDS quotes in the week of the March price spike was 30% higher than the start of the month.
The sheer size of Deutsche Bank’s CDS is also considerable. Total outstanding default swaps tied to its debt amounted to $28.9 billion of gross notional volume as of May 26, according to data from the Depository Trust & Clearing Corporation. The body provides no split between the volume tied to Deutsche Bank’s senior and subordinated debt.
Single-Name Shame
As well as complaining about a shallow market, both Enria and the European Securities and Markets Agency have also taken aim at the lack of transparency on trades in “single-name” CDS such as Deutsche Bank’s swaps, where weak disclosure could allow brokers to capitalize on moments of extreme volatility to set higher prices without proper checks. Market participants are more sympathetic to that criticism.
While more than 80% of European CDS trades are done through a central clearing house — making more information available about individual transactions — the rest of the market involves the “over the counter” buying and selling of individual banks’ CDS, according to data from ISDA SwapsInfo.
Enria has pushed the idea of forcing single-name CDS trades to go through clearing, too, but ESMA chair Verena Ross doesn’t want to impose that restriction because of risks to the central clearing infrastructure. Instead, she wants to improve the speed and granularity of reporting positions in this more shadowy part of the market.
Read More: ESMA Seeks Swaps Transparency After Deutsche Bank Turmoil
“Having this information in real time would help calm things down a little,” says Filippo Alloatti, a senior credit analyst and portfolio manager at Federated Hermes. “Marginally some of the volatility could be reduced by increased transparency. But if the market wants to panic, there’s nothing to stop the market from panicking.”
There’s also anxiety among CDS specialists that regulators could inflict unintended damage on the swaps market in an ongoing hunt for a scapegoat after March’s meltdown. The CDS world is populated by sophisticated investors, and forcing banks or investors to disclose their positions would give an edge to rivals, some bankers say, and could even stop people doing transactions — thereby drying up liquidity.
“Sometimes, it looks like a simple observation can be made by looking at CDS prices, and if there’s a sharp increase on the back of an event,” says Saul Doctor, credit strategist at JPMorgan Chase & Co. “But everything has context and there’s a lot of nuance that’s often missed.”
–With assistance from Nicholas Comfort.
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