The fact that the major credit indices have had to resort to 'imaginary credit' in order to generate an actionable market is perhaps the final nail in the coffin of the single-name CDS market in this cycle. An artificially low spread environment, forced their by massive technical flows thanks to central-bankers' financial repression has removed a natural buyer- and seller- from the market - reducing liquidity; and combined with Dodd-Frank and more regulation (higher capital reqs), dealers are also forced to delever risk books (reducing liquidity). But, there is one glaring reason why the single-name CDS market is dying; extremely high correlation. As Barclays notes, in a market where investors’ ears are, more than ever, finely tuned to the statements of politicians and central banks and the tail outcomes for the market, it makes sense for correlation to be high – at this stage, there should be little distinction between individual names – trading the level of systemic risk premia is the focus. And sure enough, index (systemic) volumes is rising as single-name (idiosyncratic risk) trading volumes and exposures are fading fast.
CDS trading volumes have increased for indices and dropped for single names. We relate this to the current market environment, with an intense focus on political/central bank headlines and high correlation between individual names. We expect index volumes to remain high (absolute and relative to single-names) as long as political headlines drive the market.
Trading volumes in sovereign CDS remain stable. Levels in recent quarters have been very stable, and sovereign is the only section of single-name CDS that has seen an increased level of trading compared with Q1 11, unsurprising given the backdrop of the sovereign crisis in Europe.
Trading volumes in single-name corporate and financial CDS are trending lower. Financial CDS trading volumes remained stable until Q1 this year, dropped into Q2 and stayed broadly unchanged over Q3. Trading volumes in corporate CDS have actually been fairly stable over the past four quarters, having experienced a large drop heading into Q4 11.
Index trading volumes remain high. In particular, trading volumes in corporate CDS indices (iTraxx Main/Crossover/HiVol) have stayed at a very high level; even higher than the reference level of Q1 11. We find it very telling that, on a relative basis, trading activity in corporate CDS indices has picked up relative to the trading activity in the front month future of SX5E. Trading volumes in financial CDS indices are erratic, but have not seen the same decrease in trading volumes experienced in single-name CDS.
Why is this happening?
Correlation between names in credit indices is very high. One key feature of credit markets is the persistent high realized correlation (chart below). At the tights in the summer of 2011, correlation was low – just north of 40%. As spreads widened towards the end of summer, correlation spiked, reaching 75% in December 2011. Correlation has never retraced to anywhere near mid-2011 levels – in spite of spreads tightening and being range-bound in Q2 12.
High correlation is symptomatic of the current environment. In a market where investors’ ears are, more than ever, finely tuned to the statements of politicians and central banks and the tail outcomes for the market, it makes sense for correlation to be high – at this stage, there should be little distinction between individual names – trading the level of risk premia is the focus.
It makes sense that single-name trading volumes suffer while index volumes are high/unchanged. In a market with high correlation between names dominated by macro headlines, the need for trading single-name CDS (apart from sovereigns) as opposed to CDS indices is reduced, and this is clearly reflected in the trend in trading volumes shown in Figure 2 and Figure 3.
Trading Volumes In The Future
CDS index trading volumes are likely to remain high – both in absolute terms but also relative to single-name volumes as long as the uncertainty regarding the future for Spain/Italy (for example) remains at the forefront, and in turn the dominant driver of returns remains levels of risk premia.
Only in an environment with more distinction between individual credits – in a recession with reduced systemic fears, say, we would expect to see single-name trading volumes increase as hedging of individual exposures becomes more relevant.
So while the technical flows on the 2005-08 period maintained by The Great Securitization maintained single-name volumes (via hedging); this time we do not have that 'hedging' f tail risk concern since your friendly local central banker has disintermediated it (or at least in his tiny mind he has). The only way single-name CDS will re-emerge is if idiosyncratic risk is every allowed back into our lives and a good old fashioned recession will divide the haves from the have-nots in terms of real cash flow and not just imaginary vendor-financed revenue streams.