CDS benefits from cash market freeze

Credit default swaps are steadily accounting for a larger proportion of flows in credit markets, as the illiquidity of bonds has seen a growing number of end-users turn to derivatives to hedge and take risk over the past year.

Dealers point to a variety of reasons to explain the interest in CDS such as demand from pension funds and assets managers, to increased standardisation of CDS to the generally hostile trading conditions.

Above all, Niall Cameron, global head of credit trading at HSBC, noted dealers holding smaller inventories of bonds helped explain the poor liquidity in the cash market and the increased use of CDS.

“Over time we’ve seen a secular increase in the use of CDS and a decrease in the use of bonds as a trading tool,” he said. “Last year we saw bonds being placed at new issue more as a buy-and-hold investment as fund managers found their ability to trade out of bond positions in secondary markets much more limited.”

Cameron pointed to a marked increase last year in the number of real-money investors that would use CDS as overlays on bonds portfolios – whether it is to take a more bearish view or to put some excess cash to work – instead of just relying on the secondary bond markets.

These players are an important addition to the mainstream CDS client-base, which was traditionally dominated by hedge funds, correlation desks and insurance companies pre-crisis.

The CDS market also became the fallback option for many traders during the most tumultuous periods of 2011. When volatility spiked in August, traders reported that much of the cash market in Europe remained frozen, particularly in peripheral sovereign debt, forcing end-users to turn to CDS to execute trades in any size.

“Although people continue to talk about the imminent death of the credit derivatives market, the reality is that once again the product demonstrated its worth last year by continuing to trade despite the almost complete breakdown of the cash market,” said Peter Duenas-Brckovich, global co-head of credit flow trading at Nomura.

“While transaction costs in derivatives had to increase to reflect the higher volatility, you could at least execute trades in good size. If anything, this continuity of trading has made people more confident in the product,” he added.

The relative illiquidity of bonds can be partly attributed to the poor conditions in the wider credit market. However, many believe it is a more permanent phenomenon driven by dealers’ bond inventories shrinking dramatically over the past five years due to rising costs.

Financing bond inventories is expensive thanks to a combination of the current crisis raising banks’ funding costs, and regulators introducing more stringent liquidity rules. Risk-weighted assets becoming costlier to hold under Basel III also disincentives long bond positions.

“There are several things happening that are unfriendly towards banks holding large inventories of bonds on their books. Whatever changes in the wider market, these trends are unlikely to be uprooted,” said Cameron.

Meanwhile, despite some negative publicity with respect to sovereign CDS last year, dealers claim customer behaviour has not altered in the corporate and financials space.

At the same time, the CDS market has continued to evolve. Contracts have become standardised, liquidity has migrated to the one-year and five-year maturities, and there has been a slow but steady push towards central clearing in order to eliminate counterparty risk.

Duenas-Brckovich also highlighted the relative transparency of CDS pricing in Europe as an important factor that has helped broaden the user-base. A handful of firms provide CDS prices publicly, which can be used by clients to accurately mark their positions.

“In the cash market you can get a wide spectrum of prices from different dealers, which are at best only tradeable in small size,” said Duenas-Brckovich. “Conversely, the transparency and homogeneity of CDS means there is broad consensus as to the ’market price’ for flow names, which are now mostly traded through Bloomberg.”