Clearing rollout boosts CDS options market

IFR 2364 - 19 Dec 2020 - 08 Jan 2021
5 min read
Christopher Whittall

Major banks are hopeful the introduction of central clearing for US credit-default swap index options will spur further activity in this market after the two main central counterparties for CDS have rolled out services in recent weeks.

ICE Clear Credit and LCH’s CDSClear are now both live clearing options on IHS Markit’s CDX North American investment-grade and high-yield indices, the major credit derivatives benchmarks tracking US corporate debt markets.

Funnelling derivatives through clearinghouses reduces the regulatory capital banks must hold against these trades and can also lower the amount of margin investors must post against their positions.

European CDS options clearing volumes at LCH have rocketed this year and banks are hopeful similar momentum can be built in the even larger US credit derivatives market.

“The CDS options market is maturing and we have very high hopes that clearing will lead to widespread adoption of the product next year,” said David Goldenberg, head of US credit derivative trading at Credit Suisse.

“Clearing will make trading options less balance-sheet intensive for banks, pricing will be more transparent and there’ll be a standardised expiry protocol that should help more investors become comfortable trading the product."

Clearinghouses act as middlemen in derivatives trades, preventing losses spreading through the financial system if one of the counterparties to a deal defaults. Over 80% of CDS volumes are now cleared, according to data from the International Swaps and Derivatives Association, up from about 50% at the start of 2014.

CDS indices – the most actively-traded type of product in these markets with over US$7trn in contracts outstanding, according to the DTCC – have accounted for the vast majority of those clearing volumes.

Moving CDS index options into clearing was a lower priority given the market is far smaller at about US$848bn. Trades are also much shorter-dated, typically three months in maturity rather than five years for indices, meaning these exposures attract less regulatory capital for bank trading desks.

Even so, the market has grown significantly over the past decade, reaching US$1.1trn in March at the height of the turmoil in financial markets – up from US$153bn nine years ago shortly after the DTCC started publishing CDS options data.

Significant savings

And experts note there are still significant savings to be made from clearing options positions. Banks don’t have to set aside as much capital facing a clearinghouse on a trade compared with other counterparties, while investors who put on multiple CDS trades with various banks can net down exposures and lower the amount of margin they must post.

“CDS options are already very liquid, with high volumes and with a large and varied group of clients trading them. Clearing will definitely help broaden even further the range of clients that can participate in that business and improve the efficiency of it," said Aymeric Paillat, global head of credit index and options trading at JP Morgan.

LCH started clearing European CDS index options in 2017 and volumes have increased to €70bn this year from €17bn in 2019 as liquidity in the inter-dealer market has grown.

Frank Soussan, head of CDSClear, said three to four clearing banks are planning to start offering options clearing services for their clients in Europe next year now that liquidity has been established in the inter-dealer market. That could provide another fillip to volumes given that there are three to four client trades for every interbank trade, he said.

"Clients want to see liquidity in clearing before doing it themselves," said Soussan. "Now we have liquidity for cleared options in Europe, it's time for clients to come in. We could see volumes in the market increase significantly."

There are already signs that a wider range of investors are embracing options, which have proved to be particularly popular in times of market stress. Volumes surged during the March turmoil in credit markets and also increased around the US elections, traders say.

“We’re increasingly finding that the credit options space is a more efficient way of hedging than standard credit indices,” said Fraser Lundie, head of credit in the international business of Federated Hermes. “We found our unconstrained fund outperformed in March because it was able to benefit from the spike in volatility, not just in credit spreads.”