Ever felt excluded from the list of people who can (allegedly) buy insurance on their neighbor's house, and then burn it down? That's all about to change. The CBOE has announced that that on Tuesday, March 8, the Exchange will begin trading newly-designed Credit Event Binary Options (CEBOs) contracts. In essence these will be like Credit Default Swaps, accessible to everyone, which will have a $1000 payoff per contract in the event of a bankruptcy before contract expiration. Since the contracts will have specific prices, they will in essence replicate the LIBOR spread on CDS (or the inverse cash bond pricing from par), and the closer a company is seen as being to bankruptcy, the higher the contract price. What this will do is to revolutionize the shorting aspect of trading, as there will be no borrowing need to express a bearish outlook on a company, and no possibility for State Street, BoNY or your favorite repo desk to pull your borrow from underneath your feet thus forcing a short squeeze. In essence, this will be a marginable equity product trading as a credit derivative. We are delighted that finally one will be able to express a bearish opinion without fears of gross market manipulation and melt up, as the CEBOs will have little or no structural relationship to what happens with the broader stock market.
From the Press Release:
Credit Event Binary Options contracts allow investors to express an opinion on whether a company will experience a "credit event" (bankruptcy). Due to inverse correlations between credit and equity markets, CEBO® contracts can be used as a hedging tool for individual stocks. The contracts also provide the advantages of price transparency available through a regulated exchange, currently unavailable in over-the-counter credit default swaps markets.
A CEBO contract has just two possible outcomes - a payout of a fixed amount if a credit event occurs or nothing if a credit event does not occur.
The CBOE, which first began trading single-name and basket Credit Event Binary Options in 2007, recently received SEC approval to amend the Credit Event Binary Options rules.
One change simplifies the terms of a payout for CEBO contracts, allowing CBOE to list CEBO contracts that specify bankruptcy as the only trigger for a payout.
The size of the CEBO contract payout if a credit event occurs has also been revised. If a bankruptcy occurs prior to expiration of the contract, the amount of the payout will be $1,000 per contract.
The ten companies that will first see bankruptcy contracts traded are the following:
- AK Steel Holding Corporation
- Advanced Micro Devices, Inc.
- Arvinmeritor, Inc.
- American Axle & Manufacturing Holdings, Inc.
- Hovnanian Enterprises, Inc.
- Huntsman Corporation
- MBIA Inc.
- The PMI Group, Inc.
- Smithfield Foods, Inc.
- Tenet Healthcare Corporation
One thing that is certain: this development will throw a wrench in long-established equity-credit cap arb models, as the sudden opening of the market to retail bets on corporate bankruptcy will have huge bilateral repercussions on every single asset class. It also means that every single quant model and factor driven investing system will have to be massive recalibrated. It also means that equities will no longer be a direct representation of corporate health, and equity and credit disconnects, long discussed on Zero Hedge over the past 2 years will suddenly be made glaringly obvious to everyone with just an equity account.
Oh, and by the way, if you thought institutional-only CDS trading ended in tears, just wait until every housewife in the world can bet on the solvency of the individual components of the S&P... We, for one, can't wait.