Is Selling US CDS A Risk-Free Way To Short The Dollar?
There has been much conjecture on whether using CDS is an effective way to hedge against US default risk. Many theoreticians, especially those of the post-March lows variety, have sprung up and are speculating that buying Credit Default Swaps on the US is ultimately a futile and pointless endeavor. The main argument: a US default would likely mean that interconnected dealers won't recognize contracts on a US default event, as they themselves will be out of business. Even if they continued to exist, like cockroaches in a postapocalyptic world, the collateral which backs derivatives is mostly US Treasurys: the same obligations that would end up being massively impaired. Furthermore, even though US CDS try to isolate currency risk by being euro denominated, a somewhat gradual collapse into default would make the dollar lose its value, which would make premium payments in euros untenable for the protection buyer. Then again, regardless of theoretical considerations, in a world fleeing from any risk, it is precisely US CDS where everyone would be rushing to: just recall the 100bps US CDS wides reached in February.
But today, when the Fed has removed all systemic or idiosyncratic risk for who knows how much longer, do US CDS serve one very unique, indirect purpose? It stands to argument that size sellers of US CDS who receive euro-denominated periodic annuities and P&L equivalent variation margin, could be a major player in the US-Euro carry trade, as protection sellers could short dollars against their euro-based cashflows. Furthermore, being a seller in a derivative which, according to the above argument, one would be faced with a credit event only in theory, permits protection sellers to sell virtually limitless amounts of US protection, thus pulling an AIG. The difference is that not only would the protection seller be in need of a bailout, but so would the entire US, thus, grotesquely offsetting the risk and in essence neutralizing it.
And with the Roubinis of the world now screaming against the dollar-carry bandwagon, could the source of the actual currency imbalance be found in this arcane trade?
Some additional observations on the theoretical aspect of US protection transaction is the topic of Moody's most recently Weekly Credit Outlook piece. The rating agency's arguments do not differ much from those who believe risk is dead and buried.
The price of credit default swap (CDS) protection on the debt obligations of the U.S. government has been increasing in recent months, last week last reaching 34bps - the highest level since July. While interesting, the focus on the gyrations in the price of CDS on the U.S. seems to ignore this basic question – can one effectively hedge the risk of a U.S. “default” with credit default swaps? We think not.
Needless to say, the world in which the U.S. would default on its debt would be a world in crisis – a crisis, of which such an event would likely not be the beginning and almost certainly not the end. However, rather than explore the probability or the indirect consequences of a U.S. credit event, we focus on the mechanics of the CDS market coupled with some practical analysis.
The market for U.S. CDS is not especially large -- $11.1 billion in gross notional and $2.2 billion in net notional amounts. As is true of the OTC derivatives market in general, the major dealer-banks are the market-makers for U.S. CDS.
However, U.S.-based dealers generally do not participate. The market appreciates that buying credit protection on the U.S. from a U.S.-based bank is probably a futile endeavor for if the U.S. cannot meet its obligations, odds are – neither would the U.S.-domiciled dealers. As prices change driven by the market’s views of the probability of a credit event, the contracts are marked to market and the in-the-money party receives collateral against its unrealized P/L.
U.S. CDS contracts are also denominated in euros, making them quanto-like. If the U.S. were to experience a credit event, the dollar would very likely fall in value, and if the contract were settled in dollars, the protection buyer’s economics would be adversely affected. By denominating U.S. CDS contracts in euros, the market has sought to mitigate this risk.
Based on the above, it seems that the contracts and market practices have been engineered to eliminate the two most obvious risks – counterparty and currency. Still, we think that this is one of the cases where financial engineering is likely to be no match for practical reality.
Why? Firstly, an obvious point – major dealers are riskier credits than the U.S. government. The fact that they may put up collateral against their derivative obligations offers little relief because U.S. Treasuries (the very instruments on which the credit event would occur) represent a large portion of such collateral between counterparties.Secondly, given the interconnectedness among the major global dealers, the confidence-sensitive nature of their funding, and the very large exposures they all have to the U.S. market, we think that the “wrong-way” risk of buying protection on the U.S. from any major dealer is very high. In fact, the CDS market sends a similar signal as the correlation of CDS spreads – among the dealers and to the U.S. – is indeed quite high.
Finally, the currency risk is not fully mitigated either unless the credit event happens very abruptly. With the increase in the probability of a U.S. credit event, the dollar would likely fall making euro-denominated premium payments more expensive for a protection buyer with dollar-denominated P/L.
In summary, we do not think that CDS would be an effective economic hedge against a U.S. credit event. Of course, protection buyers might use U.S. CDS without actually expecting a credit event to occur. Uses might include “macro hedging” against rising credit spreads, “managing” the country risk limit, or betting on rising credit spreads. It is worth noting, however, that in this case the protection buyer is exposed to an unfavorable asymmetry of outcomes, which is unusual for CDS. While a credit event is not expected (or if it happens, the protection is worthless), the protection is guaranteed to expire worthless upon maturity.
While we disagree with Moody's that a US CDS contract is impractical, and have been fans of purchasing US CDS since it hit all time lows in the 20 bps range, the likelihood that portfolio managers do subscribe to this view is high. And taking the mechanics of the cash flow into consideration, and the perceived lack of virtually any obligation upon the occurrence of a possible outcome (which as Moody noted is a lack of any contractual responsibility to the protection buyer), the US CDS seller syndicate could easily be one of the key sources of dollar short funding: with sellers pocketing euros and immediately going to market and selling dollars.
The problem with this argument is that the size of this market is relatively tiny from an F/X perspective: there is only $11.1 billion in gross US CDS notional. Yet if the marginal seller is involved in a carry-type trade, a dollar-short unwind would probably have repercussions in the US CDS market. Not only would the dollar spike, but paradoxically US credit risk would probably widen dramatically. If that happens, the correlation desks' response would be to unwind matched pair trades, which could potentially have a cascading effect on a slew of interest rate products, not last of all US Treasuries.
Which is why any unwind at the heart of the prevalent risk trade now: the massive dollar carry, would impact virtually every investment product, quite possibly in self-referential feedback loops. If correct, it merely shows how much more the Fed has at stake in keeping the dollar depressed than merely getting mom and pop to buy Amazon at $130/share. Losing control of the carry trade will be the systemic equivalent of allowing Lehman's book to be marked-to-market: a potentially complete collapse in systemic confidence, which would have such far ranging implications as the $300 trillion interest rate derivative market. And when sudden volatility reaches this product universe which is 6 times bigger than world GDP, the events from last year will seem like a dress rehearsal.
A primer on sovereign defaults: when the reference entity is a sovereign, such as the U.S., a credit event includes the failure to pay interest or principal on Treasuries or government-guaranteed debt, a repudiation/moratorium of existing debt obligations, or a restructuring of the terms of obligations that disadvantages creditors.