CDS Market Begins Trading Imaginary Credit With LIBOR-Style Fixings

Tyler Durden's picture


We have not been aggressive anti-CDS fanatics in the past - since the ignorance of mainstream media types satisfies that need - as the reality in the credit market is less extreme than many would love it to be. However, the latest move by Markit and its self-aggrandizing dealer owner/clients, to bring names into the high-yield credit index that do not even have CDS trading on them, is simply remarkable. While they will defend the move on the basis that it will force dealers to provide single-name CDS liquidity in three of the high-yield credit markets most-indebted companies (CIT, Charter Comms, and Calpine), the fact is that they are using the liquidity/fungibility of the index to enable risk to be unwound on what is likely bloated balance sheets containing too much of this crap. By imagining (or fixing LIBOR-style) where the CDS would trade, based on where the firms' bonds trade, we worry that the hitherto somewhat liquid source of 'fast' macro-hedging or positioning has become even more manipulable than before - and in the event of a default (or stress/illiquidity event), we can only imagine the law-suits. As the FT notes - all this does is provide more 'arbitrage' opportunities as opposed to real hedging; simply amazing that as with equities - it is now the synthetic indices that run the entire market.

There are three glaring problems:-

1) The skew between where credit indices trade and their underlying components is incredibly flow-dependent and difficult to model - this addition of 'fake' instruments makes that even more ridiculous (here is a chart of the spread - lower pane) between the index and its fair-value - that should not exist in reality if the markets were efficient and liquid):

2) The basis between where CDS trade and where the bond trades (and which bond is cheapest to deliver and all the complications involved there) make the pricing of the CDS in reality (versus a model) much more complex... (here is a chart proxying the spread between where CDS markets and bond markets trade - again - theoretically a non-existent (or stable) differential that as is clear is incredibly nopisy and liquidity dependent)...


3) If dealers DO NOT step up and make single-name CDS markets in these 3 firms, quotes wil be fixed in a LIBOR-style polling method!!!!

and while the FT below make it clear that they 'doubt' the dealer's good will also - just read the self-congratulatory note from Markit and Barclays...

Via FT: Wall Street Engineering Revival Of CDS

Wall Street financial engineers have devised a new way to combat declining trading in the credit derivatives market – they are revamping an index to add financial instruments that do not exist.


Indices that track the price of credit default swaps (CDS), contracts which act as insurance against a default on corporate bond payments, have become a popular way for banks and hedge funds to speculate on the creditworthiness...


But underlying CDS trading has shrivelled to such an extent that there are not enough actively traded names to make up a 100-company index.


This week, the index provider, Markit, will cross a Rubicon and begin to include three companies in its North American high-yield CDX index for which no bank is offering a CDS.


Markit and derivatives traders hope the addition of CIT Group, Charter Communications and Calpine Corp will force banks to launch CDS on the three companies.


Global trading in individual corporate CDS is down 23 per cent by volume this year, according to the Depository Trust & Clearing Corp.


Some people are warning that the illiquidity of the underlying market risks a repeat of debacles such as the JPMorgan “London whale” trades in which the bank lost $5bn on a trade involving a CDX index.


Ed Grebeck, chief executive of Tempus Advisors, said that traders would be able to exploit any wide disparities between the underlying CDS prices and the price of the index, while the index itself will become an increasingly imperfect hedge for the credit risks of a bond portfolio.


“These indices provide a false sense of comfort,” Mr Grebeck said. “The best way to hedge your credit risk is to manage your credit risk in the first place. This provides users of the index greater opportunity to conduct arbitrage, as opposed to helping institutions to hedge their risks.”


The prices of Markit’s CDX indices are set at a daily fixing using quotes provided by dealers, excluding outlier quotes, a process the company says mirrors the one used to calculate Libor – the interbank lending rate that has become the subject of a slew of regulatory inquiries into possible manipulation.


Deepak Agnani, head of US credit indices at Markit, said the process for choosing additional names was transparent and conducted in consultation with dealers. “We have picked the three companies that have the highest amount of debt outstanding,” he said. “They are names that should be put in focus by the CDS community.”


Barclays strategists led by Brad Rogoff, writing in a recent note to clients, said that they expected the emergence of CDS trading in CIT, Charter and Calpine after the index goes live this Thursday.


“The belief is that CDX inclusion will drive single-name CDS trading through index arbitrage, thereby broadening the base of CDS liquidity that has otherwise been shrinking to an ever-smaller group of credits. We concur with this view and are excited about the prospect for enhanced liquidity in high yield derivative markets.”

Bottom-Line: So apart from basis risk, skew risk, and LIBOR-style fixings - this is all good right?; it would seem the dealers got just want they wanted... every time someone trades the liquid index they create a fractional risk position in one of these three imaginary credit derivative positions and that is something the dealers can 'use' to offset positions or charge off to clients looking to hedge a previously unhedgeable and illiquid market. With high-yield prices right up against call constraints, we suspect things at the margin are getting a little nerve-wracking for everyone who rode this wave up...

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Tue, 09/25/2012 - 13:32 | 2828594 SafelyGraze
SafelyGraze's picture

The Aristocrats are now placing ads in the zh margin

Tue, 09/25/2012 - 13:39 | 2828629 cougar_w
cougar_w's picture

You'll know we've crossed the Rubicon when Tyler posts something about where to get the best foie gras while vacationing in the Caymans.

Wed, 12/19/2012 - 00:58 | 3077631 Jeelan
Jeelan's picture

what no longer trades. but would trade at, if they hadn't destroyed the market with their sheer genius.yorkshire search engine optimisation

Tue, 09/25/2012 - 15:06 | 2829009 SafelyGraze
SafelyGraze's picture

that's right. *those* aristocrats.

the dirty dirty incestuous copraphilic bestial disgusting family act. you've seen them perform before. they all wear white shirts. 

and that's who you invest in gold for.

Tue, 09/25/2012 - 13:33 | 2828603 Jonas Parker
Jonas Parker's picture

Who knew shuffling worthless paper could be so profitable?

Tue, 09/25/2012 - 13:35 | 2828614 cougar_w
cougar_w's picture

I have a new arbitrage opportunity. I think it's going to be huge:

When the Four Horsemen of the Apocalypse finally arrive, take out CDS on Homo Sapiens.

I'm not sure how anyone collects though. With luck I'll have pocketed a lot of subscription money before I have to work that part out.

Tue, 09/25/2012 - 13:35 | 2828617 Confundido
Confundido's picture

The best hedge is not to own the asset. I've been in this market long enough to know that pretending that you have a hedge via cds is the most idiotic form of risk management you can come up with...

Tue, 09/25/2012 - 13:39 | 2828630 slaughterer
slaughterer's picture

I have found selling CDS to be a pretty good hedge. 

Tue, 09/25/2012 - 13:50 | 2828667 NotApplicable
NotApplicable's picture

You mean, it used to be the most idiotic form of risk management.

Now it's even more better, with fake indices to "track" what no longer trades. but would trade at, if they hadn't destroyed the market with their sheer genius.

Unicorn fart index next?

Tue, 09/25/2012 - 15:09 | 2829026 TraitorsHang
Tue, 09/25/2012 - 14:06 | 2828725 LULZBank
LULZBank's picture


most idiotic form of risk management you can come up with...

It might be idiotic but its the most highly recommended form.

Right up there with property prices will never come down.

Tue, 09/25/2012 - 13:37 | 2828620 Confundido
Confundido's picture

Calpine? Any one still remembers how they filed for Ch 11 at 10pm, 3hrs later than the 7pm cds contract expiry? 

Tue, 09/25/2012 - 13:56 | 2828688 buzzsaw99
buzzsaw99's picture

cpn investors will get to be corz-enron-ed twice. that reminds me of the joke about the bear hunter. lulz

Tue, 09/25/2012 - 13:41 | 2828638 Ham-bone
Ham-bone's picture

The fact that ZH is "amazed" by anything any longer is, well, amazing.

Tue, 09/25/2012 - 13:45 | 2828651 Jonas Parker
Jonas Parker's picture

I don't think we're all that jaded... quite yet.

Tue, 09/25/2012 - 13:51 | 2828671 NotApplicable
NotApplicable's picture

He who jades first, jades best.

Wed, 01/02/2013 - 05:23 | 3114281 Jeelan
Jeelan's picture

The kitchen sink but taking much of the rest of the plumbing out of the walls and hurling it at the paper markets. Yet even through one of the fastest additions of short interest we’ve seen throughout this entire bull market, the cartel has little to show for it’s bankruptcy in Canada

Tue, 09/25/2012 - 13:50 | 2828668 Al Huxley
Al Huxley's picture

'Libor-style Fixings' - sounds like a menu item in a diner.  In related news...,3082/

Tue, 09/25/2012 - 13:54 | 2828686 cougar_w
cougar_w's picture

The Onion totally rox.

Tue, 09/25/2012 - 13:55 | 2828690 NotApplicable
NotApplicable's picture

Don't you mean, "Libor-style Fixin's?" Don't they come in the KFC feed-bucket combo?


In other news; Markit is libor-style.

Tue, 09/25/2012 - 13:58 | 2828697 NEOSERF
NEOSERF's picture

Things are starting to move fast in Europe and yet as we get closer to our own fiscal cliff we hear nothing from ratings agencies.  Have they learned nothing.  I can understand prudence and not wanting create a self-fulfilling situation but really?

My ratings:

Spain - Junk (Depression)

Greece - Junk (Depression)

Portugal - Junk (Depression)

Hungary - Junk (Depression

Cyprus - Junk (unending handouts necessary)

Japan - Junk (selective default coming soon)

Italy - Junk (poor politics, Monti gone in April, lack of competiveness, corruption)

China - A (poor politics, no control on regional spending, corruption, human rights and immature/ineffective legal situation offset by reserves)

UK - A ( only on effort, own currency and understanding the issue)

US - AA ( own currency, understanding of issue but lack of political will and clock ticking quickly)

Germany - AA (productivity offset by euro mess and IOUs are getting huge)

France - A (Basel III will put their banks under)


Tue, 09/25/2012 - 14:04 | 2828719 slaughterer
slaughterer's picture

NEOSERF: please rate following popular stocks:












Tue, 09/25/2012 - 15:07 | 2829010 Scalaris
Scalaris's picture


"Cyprus - Junk (unending handouts necessary)"

How dare you Sir, we here in Cyprus, do in fact produce an abundant return of negative productivity through our sole employer, that is the public sector, and I do vehemently reject any fault whatsoever, from our part, simply because someone decided to check the actual "balance sheets", after realizing that the neverending, government-largesse-providing teat, was running on borrowed money and time, since nineteen-always.

P.S. We also manufacture some famous, traditional Cypriot cheeses, whose production has unfortunately being outsourced in China, or some other exotic place.

Tue, 09/25/2012 - 14:02 | 2828708 LongSoupLine
LongSoupLine's picture



The huge pile of shit is actually in a hole, not level ground.

Tue, 09/25/2012 - 14:04 | 2828718 LULZBank
LULZBank's picture

That will surely create tons of jobs and put the economy back on track.

Tue, 09/25/2012 - 14:06 | 2828724 Arnold Ziffel
Arnold Ziffel's picture

What's in it for me?

Tue, 09/25/2012 - 14:37 | 2828850 Quinvarius
Quinvarius's picture

When do they install the slot machines on the trading floor and put online poker in my portfolio?  LOL.  What a fkn joke our financial system is.  A complete farce with absolutely no use in the real world.  Yet I am forced to assist in bailing out.


Tue, 09/25/2012 - 16:16 | 2829339 marathonman
marathonman's picture

It's more like Texas Hold 'Em.  You only see your cards and the cards on the table.  The house sees the rest of the deck so they know whats in your hand.  No sense in bluffin'.  You either have the best hand and/or your account is still rehypothecated to the house anyway.  It's quite a free-wheelin' casino.

Wed, 09/26/2012 - 04:05 | 2831051 Colonel Klink
Colonel Klink's picture

Those have been there the whole time.  Almost all of them two arm bandits.  Seems as if most of them have a black push button on top of their head.

Tue, 09/25/2012 - 15:28 | 2829134 newworldorder
newworldorder's picture

Please provide Example in plain English explaining this article.

Tue, 09/25/2012 - 16:51 | 2829553 CPL
CPL's picture

It's like naked short selling in reverse. Selling assets you don't own and hoping to fill the gap with something.


In this case liquidity globally is about to get lock jaw like 2008.  Cheques bounce, payments late because there is too much money in the system to contain.


Outcomes include Inflation, government collapse (like Greece)...if this is true then all of them go down with the ship in one go because all banks opted three years ago to sew themselves together as a mutant policy factory.  All banks across the world with a central bank are the same bank.  When the US prints credit, they all have to print.

Tue, 09/25/2012 - 17:15 | 2829702 Dr Benway
Dr Benway's picture

You know how a stock market index is made up of various stocks, and the index value is calculated from the stocks' prices?


Imagine adding a company to this stock market index, even if the company is not traded on a stock exchange, by estimating a 'share value' for the company based on its bond price.


In the same way, a CDS index is made up of constituent CDS, which now have had an addition of a virtual CDS.

Tue, 09/25/2012 - 18:27 | 2829973 larz
larz's picture

That does it Im going to start paying imaginary taxes and bills  weeee!

Wed, 09/26/2012 - 02:50 | 2831013 Ghordius
Ghordius's picture

BAN CDS "We have not been aggressive anti-CDS fanatics in the past" - well, it's about time. BAN CDS

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