Quanto CDS flows return

Dealers are welcoming increased flows in quanto credit default swaps referencing European countries, after sustaining heavy losses on positions during 2010’s sovereign debt crisis. A wave of investors putting on negative basis packages has spurred CDS protection buying on European sovereigns with payments in euros, helping market-makers balance portfolios in what had been a predominantly one-way market.

“We are trading an increasing amount of bond CDS basis packages in sovereigns. These naturally trade in the same currency and help expand the investor base for CDS in euros,” said David Cross, head of sovereign derivatives at JP Morgan in London.

The risks of quanto CDS (whereby a CDS can be quoted in two currencies) came to the fore around the time of the Greek crisis in 2010, when observers began to speculate that the beleaguered nation might be forced to leave the European Monetary Union.

The basis between Greek CDS with payments in US dollars (the standard contract) and in euros (the quanto) leapt to 100bp, having traded as close as 1bp in 2006. As sovereign risk contagion spread to other peripheral European countries, many desks are thought to have incurred losses on their quanto positions, which became an ever more important risk to monitor.

“From mid-2010, as the market re-evaluated its sovereign risk profile, quanto positions finally became highlighted as a risk in their own right and hedged accordingly. This is evident in the sharp sell-off of euro CDS relative to US dollar throughout the rest of 2010,” said Cross.

Payments in standard European sovereign CDS are made in US dollars to avoid the strong correlation between the creditworthiness of members of the single-currency union and the value of the euro. This has made buying euro CDS an unpopular hedge, as the value of that protection is likely to diminish as the referenced sovereign approaches default.

There has been interest in the past in selling quanto CDS , though. The main source of supply stems from credit-linked notes, where investors buy government bonds and sell the relevant CDS to enhance the yield. In this instance, having an exact profile match between the currency of the bond and the CDS is preferable for investors. These flows put dealers in a bind, though – anaemic buying interest in quanto CDS leaves desks with one-way positions.

“The liquidity in quanto CDS has been fairly limited, and the Street tends to have some direction, which means it can be quite painful for dealers to find liquidity,” added one dealer.

An uptick in investors looking to cash in on the negative basis between some peripheral European sovereign bonds and their CDS has evened up the flows in recent times, bringing more liquidity to the market. Estimates vary, but major dealers say 5%–10% of their European CDS flows are in quantos nowadays.

“Quanto CDS flows have definitely picked up – basis players are buying in euros now, and that never happened before because the basis wasn’t materially negative enough to prove interesting,” said Joe Woodhouse, a director in credit derivatives trading at Credit Suisse in London.

The uptick in buying interest is no doubt welcome. However, the relative illiquidity of the market means there is no generic rule as to how quantos trade relative to the standard contract. Theoretically, the larger the spread between the quanto and the standard contract, the more significant impact the default of that name would have on the euro – but this rarely plays out in practice.

“Austria’s quanto [CDS] trades around 50% of the standard spread, which is effectively saying it is the most important arbiter of the sanctity of the euro, and that clearly makes no sense,” said Woodhouse.

Antoine Cornut, head of European credit trading at Deutsche Bank in London, said flows were the defining factor in quanto pricing. Investors have been snapping up CLNs referencing Spain, for example, increasing selling interest on the Spanish quanto. As a result, the quanto trades around 65bp tighter than the standard five-year CDS, whereas in theory the quanto should be trading more like 20bp tighter, said Cornut.

“We calculate using models that the quanto should be around 10% tighter than the five-year CDS,” he said. “The market goes through stages: right now we see bullish demand for CLNs, making the quanto swing from quite tight to quite wide – it’s volatile.”

Opportunities surface

The level where quanto CDS is trading presents opportunities for investors as well, Cornut said. CDS on France trades at 62bp and the quanto at 30bp – a cheap way of hedging French credit risk. In contrast, managing the quanto risk can be problematic for dealers.

“If you’ve bought euro protection and sold dollar protection, as the creditworthiness of the sovereign deteriorates the protection becomes less valuable and as the spreads go wider you’ll get longer, and vice versa,” said Tim Gately, European head of credit trading at Citi in London. “That’s obviously a big risk that you need to manage.”

Some of the risk can be hedged in the FX market. However, the gap risk – how much the euro tanks against the US dollar if a European sovereign defaults – is hard to cover.

“You can hedge 75% of the risk in the forward FX market, but it’s difficult to cover a massive move wider in dollar-euro,” said Cornut. “You can use FX options, but it’s expensive – you pay bid-offer and sometimes don’t get the liquidity you need on large positions. Ultimately, you have to take a view on that gap risk.”

The idea of dealers warehousing quanto risk may ring some alarm bells. After all, not everyone has a flawless track record in this area. Other quanto products such as long-dated Japanese PRDCs inflicted substantial losses on some houses in 2008. Gately signalled that dealers would be wary of these examples when managing their books.

“Most desks are only willing to take a certain amount of quanto risk,” he said. “It’s always going to be capped to liquidity on the euro side of the market. I think people are cognisant of the dangers of quanto risk and are going to be much more proactive in hedging it out in future.”

Christopher Whittall