Earlier this month, the International Swaps and Derivatives Association (ISDA) published a research report that began by noting the massive decrease in the notional value of credit default swaps (CDSs) in recent years. CDSs shrank from nearly $60 trillion in 2007 to $25 trillion by the end of 2012. That decline, suggested the Financial Times, means that CDSs are on their deathbed.
CDSs are not as useful as they have been in the past, especially for CDSs that only refer to a single bond or loan (single-name CDSs). Although canceling redundant trades explains much of the reduction in CDS notional value, behind the CDS market decline is a changing credit market landscape on several fronts. In a 2012 article, I noted the main reasons why CDSs are used:
- hedging an existing credit risk;
- reducing regulatory capital;
- speculation, including gaining exposure to a credit without having to buy the cash instrument;
- reducing (mark-to-market) income statement volatility;
- booking accounting profits through a negative basis trade; and
- trading the risk of mispriced (correlated) bonds.
In each of these categories, credit markets have made CDSs less useful.
As the FT article noted, corporate bond defaults are at historic lows, reducing the need to hedge credit risk with CDSs. Regulatory changes have also made it more difficult to use CDS hedges to reduce capital requirements. The main danger in bond markets right now is not credit risk but price risk from uncertainty about economic growth and the Federal Reserve's eventual reduction of its bond buying programs.
The CDS market also grew as a speculator's market. A 2008 estimate found that 80% were used by parties for a purpose other than seeking to insure against the default of a bond they actually owned. Recent years, however, have given traders less to spectulate on. Volatility in bond markets fell to a post-financial crisis low in 2012. Costly new margin regulations also means it will make less sense to use CDSs to speculate. And with less bond volatility, there is less of a need to use CDSs to reduce any corresponding income statement volatility.
The collapse of the private-label residential mortgage bond market further reduced the need for CDSs. Gone along with mortgage bonds is the demand for CDSs in synthetic securitizations and the opportunity to use CDSs in negative basis trades and correlation trades of mispriced mortgage-related bonds.
Although the CDS market may be down, it seems far from out. ISDA's report concluded that if we look at transactions that affect market risk, the CDS market is alive and well. From February to July 2013, transaction activity increased over the previous year by 15% to $17.3 trillion.
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