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...
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...