CDS Traders Haven't Lost Their Shirts, But They Can Be Naked

Tyler Durden's picture

Via Peter Tchir of TF Market Advisors

The European Union failed to approve a law or plan to bank naked shorts on sovereign CDS.  Their focus on CDS trading started over 18 months ago when the Greek Finance Minister said that all the short sellers would lose their shirts. There have been a multitude of rumors that it would be banned, but there are many better ways to control the CDS market.

One simple thing, is the ECB could set up swap lines with banks and sell CDS. This was first suggested to me by Faros Trading.  It makes sense.  If the ECB can buy bonds and interfere in the bond markets, there is no reason why they couldn't do it in the CDS market.  The CDS markets are much smaller, so they would get much more bang for the buck by intervening in the CDS market.  France and Italy both have about $25 billion of net CDS outstanding according to DTCC. That compares to 1.6 and 1.3 trillion Euro of debt outstanding for those 2 countries.  The ECB could easily push CDS spreads tighter.

My guess is that with minimal selling (a couple billion) they could push a name like Italy from just over 500 to something close to 200.  The problem is that they would find that the impact on the bond market is minimal.  When the ECB was intervening in the Bond markets in August, it was able to push the entire Italian yield curve over 100 bps lower.  At the same time CDS for Italy, actually moved a touch wider.  So there is some link between CDS and bond yields but it varies over time, and government (central bank) intervention in that market, would impact CDS but it would also like shift the relationship between bonds and CDS.  The bond market is just so much bigger than CDS that even a dramatic tightening in CDS wouldn't translate to a big move in bond

They could take some other simple steps that would reduce the impact of CDS on the markets.  They could force higher margin requirements for both buyers and sellers of protection.  The sellers are as much a part of the alleged CDS "problem" as the buyers.  Force mandatory margin requirements that are as high or higher than the margin requirements for levering a bond position.  By making CDS less attractive to sellers, they would shrink the size of the market, but still allow it to be a market.  Maybe they need to create more onerous terms for protection buyers.  I'm less keen on this, since the most you could ask as margin from the protection buyer is the present value if the CDS traded at 0 bps.

Maybe the margin should also apply to banks.  Most banks have one way margin agreements with hedge funds.  Forcing the banks to post margin would do 2 things.  The obvious one is that it would reduce their willingness to sell protection or run inventory as it would have a bigger impact on them.  The other, and more subtle benefit is that as spreads widen on the names the banks sold to the hedge funds, the hedge funds will have less need to buy protection on their counterparties.  The proper hedging of books does create a self-reinforcing trend.  If you have bought a lot of protection from a bank, and spreads widen and you are deep in the money, it may be prudent to buy protection on that bank from another bank.  That can push spreads further. This is most likely to occur where the underlying trades reference banks or sovereigns as the potential for systematic problems increases as spreads of banks and sovereigns widen.

Which leads to the logical conclusion that as much CDS as possible should be forced onto exchanges.  I can't help but look at the volumes that trade for ES (S&P stock futures) and wonder why it can't be done for CDS.  The volumes for stock futures are massive and the volatility is higher than that of CDS "prices".  Even names like Bank of America have basically traded in a 7% range during the past couple of months.  I don't hear traders complaining about the counterparty risk of the exchange, so if it can work for stocks it should certainly be able to work for credit.  This would actually turn it into more of a market.  It would make trading and price discovery better.  Why they have failed to take these steps 3 years after Lehman is just a total failure of regulators.  The street might make less money, but I suspect the best firms will still make a lot of money - last time I checked GS still had a big equity business.  To remove the systematic risk, slightly reduced bank P&L would be a small price to pay.

In the meantime, they should push banks to regularly clean up all their matched trades.  The banks have made big improvements on that and gross notionals have come down dramatically, but maybe they can be forced to do it even more often. Maybe "curve" trades could be something that is reported by DTCC. Although Italian and French net notionals are both about $25 billion, the gross notionals are $120 billion for France and over $300 billion for Italy.  So either Italy has a lot more curve trades on or it has been much more actively traded and left a lot of dealers with books filled with offsetting positions. It is probably some combination of the two, but continued effort to reduce the gross notionals would provide additional comfort to the overall markets while they work on implementing an exchange or cleared solution.

Index arb can be another source of creating what looks like "net" exposure and dramatically increasing "gross" exposure.  The arb is when a counterparty say sells all 125 names in the IG index, and then buys the IG index.  Since the single names and index both trade with the SNAC protocol, this is an exercise in getting execution so that the up front payments from all the single names and index are positive to the hedge fund.  After that, the flows are identical, because although we call it an "Index" it is really a portfolio trade.  The IG Index trade is documented as a portfolio of 125 identical single name trades. The arbs are typically forced to hold the position while the index remains "rich" or "cheap".  They need the index to revert from "rich" to "cheap" or vice versa so they can repeat the process.  It would be interesting to know how much of the gross and net notionals come from index arb.  Maybe that is something the regulators could force on the system.  It wouldn't change the dynamics in the market and it may reassure the system when people can see that there is even less exposure to each name once the arb activity is accounted for.

In all likelihood, the politicians will remain intent on banning CDS.  I think they will be disappointed with the impact and realize that CDS is not the root of all evil and Europe will still have a sovereign debt crisis, without the benefit now of some short covering and additional price discovery.  I think if they looked at some of these suggestions they could make a lot of improvements to how CDS is traded on limit the unfounded fear that often does affect the financial system.  

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entendance's picture

No media, and probably a column published today and nothing more about this. You wouldnt know anything of this without the internet.
OCCUPY-WALL-STREET-PROTESTERS-ARRESTS( Sept 20, 2011) Spread This Video Please.

LookingWithAmazement's picture

Obama will be re-elected in 2012. Not because he's so good, but the others are worse or divided.

SheepDog-One's picture

Nope, youre wrong, Obama will NOT be 're-elected', I guarantee that...he WILL be put in place by the banksters as a martial law COG Continuity of Government president though when the country collapses very soon.

The sheeple of america really have no idea whats coming next for them, I find it hillarious!

LookingWithAmazement's picture

So you're a "collapse-believer". What exactly will collapse then?

SheepDog-One's picture

And youre so 'Nah, everythings fine really theyre trying to fix it all so you and I can have a good comfy life, really they are'....hey good luck with that man, youll need it.

BTW what I was talking about was not pulled out of my ass, that was from a leaked CIA memo look it up yourself, 'CIA Obama last president' on youtube should get you to it.

LookingWithAmazement's picture

So far politicians were successful. No Armageddon. You have a direct link on YouTube?

fuu's picture

Don't fret precious I'm here,
step away from the window
and go back to sleep

Lay your head down child
I won't let the boogeyman come
Countin' bodies like sheep
To the rhythm of the war drums
Pay no mind to the rabble
Pay no mind to the rabble
Head down, go to sleep
To the rhythm of the war drums

GeneMarchbanks's picture

Rather than getting arrested and your typical nonsensical heroics, I'd prefer an educated revolt within the financial gulag that Wall St has created. At this point I'm convinced closing money markets or buying PMs is superior.

GeneMarchbanks's picture

Likewise. You're a nice piece of fractal...

fuu's picture

What should people who do not have money market accounts, no jobs, and no PM's do?

GeneMarchbanks's picture

Great question. Certainly not asking questions at a financial blog. Your point is made however the occupywallst movement is clearly organized by interests with money.

Bob's picture

You mean if they weren't getting paid, there wouldn't be even a thousand people in this entire country who would be willing to occupy Wall Street?

Now that's hopeless. 

fuu's picture

That may be a point, it's just not my point.

My point was that if you do not have a money market, PM's, etc then perhaps all that is left is "getting arrested and your typical nonsensical heroics". I was also hoping you actually had an idea or two on how to have an educated revolt that includes other people besides the monied ones.

AdahPrice's picture

Join the Ron Paul campaign, and arrange to go door-to-door hanging Ron Paul flyers on doorknobs, before the primary elections.  Not only will you be working for a noble cause, but you will be joining a phyle (re: The Diamond Age).  After the blowup occurs, everyone will have to join some phyle to survive.

topcallingtroll's picture

CDS and their related options are just the messenger. They provide crucial information about the state of finances of the underlying asset.

Politicians would prefer to control the sources of information, hence ban CDS. It has been hard for european politicians to lie and deceive the people when there is a snitch out there telling everyone the truth.

equity_momo's picture

I dont like the CDS market as it allows cockroaches like Goldman to game the system in their favor , a la AIG , HOWEVER , if you go around banning this and that , or putting restrictions on shorts or naked shorts , the market will find other ways to punish companies , soveriegns , currencies. It always does.

Short selling ban on financial stocks? Then long only investors run for the exit putting pressue on price and this is magnified with no shorts to give financials a bid.

CDS ban? Then bond investors will reduce exposure if they cannot hedge and those wanting to take an outright short will do so elsewhere putting pressure on other instruments , especially upward pressure on rates.

It all comes out in the wash.   If a companies balance sheet and business is sound , shorts will utlimately get burnt. If a countries balance sheet and politicis is sound , then shorts will ultimately get burnt.

Shorts are the last bastion of democracy. Those betting against "the system" are doing us all a favour. When you see governments impose capital controls and whatnot , you know its a fucked up situation. Freedom? Democracy? I cast my vote by betting against the ponzi - without that ability its a hop skip and jump to a fully planned economy and some spiffy new uniforms.


Viva la shorts.

Paul67's picture

Great idea; lets fix one ponzi scheme with another ponzi scheme.

Yah that’s the ticket, now back to my wife........ Morgan Fairchild.........., whom I’ve also seen naked.

LookingWithAmazement's picture

PMs don't rise so steeply anymore; investors turn to "undervalued" gold stocks, where risk is lower. Or will the folks at KWN ("gold to $12.000") eventually get it right?

SheepDog-One's picture

Thats because gold is also manipulated heavily by the world central banksters. Yea they want you to buy 'gold stocks' instead. And no, I dont believe the 'Gold to $12,000' people have it 'right', because they havent factored in a world where gold is $12,000 'dollars' also means we've totaly collapsed, and youre spending your days trying to fight off mobs of people who want to kill you and take your gold or whatever else youve got.

Paul67's picture

Correct, a world with Gold at 12K/oz doesn’t buy what 12K does today. Hence why you need a fixed rate fiat debt on a real asset in order to leverage the increases in any PM appreciation.

buzzsaw99's picture

CDS are a scam. The sellers have no intention of paying off ever. Heads they win, tails the taxpayer loses. I wish I could sell me some CDS.

equity_momo's picture

Keep that train of thought , follow it through and where does that end up? Reset occurs sooner or later. CDS sellers are doing us a favour as those seeking the most efficient use of capital will ultimately win - and the mispricing of risk and mis allocation of capital , ie governments and government sponsored entities (including Wall St) , will be forced to act as capital dictates.

We have a deflationary collapse or a hyperinflationary collapse. The former will be the least messy for society.  Do you really think the elite will do better through pricing the plebs out of food or just pricing them out of their own hopes and aspirations. People will suck up alot of misery if they are fed and kept warm. Hyperinflation does neither.  We are in the great unwind and governments will get taken to the cleaners until markert forces are sated. That means lower RELATIVE prices. Id guess that means lower nominal prices.

That does not mean gold collapses , we clearly need an anchor point and golds suppression over the last 30 years is still being unwound along with the mispricing of risk assets. Gold is not a risk asset.

In a World of no growth (IMF will be downgrading from 4 to 3.5 and from 3.5 to 2.5 etcetc as theyre always behind the curve) this is the only outcome possible.

Robslob's picture

This is BULLISH!

Michelle's picture

Naked CDS are a problem, a BIG PROBLEM, and this market should disappear! It's pure gambling and when they trigger causes liquidity problems in the markets. Protecting this market is insanity and is no more insane than deciding to build a bomb in my backyard and then expecting the government to pay for all the carnage when I decide to pull the trigger.

SheepDog-One's picture

Yet the 'Gubment regulators' now want to 'protect us' from 'risky gold trading' by gathering up your gold and handing you a voucher in return, according to congress.

topcallingtroll's picture

Buying a swap from a counterparty who has no ability to pay up is a naked cds in my judgment.

My counterparty doesnt have to own the asset I might demand he swap, he just needs access to the capital necessary to make good on his promise.

If only those who own the underlying asset could sell swaps it would be an even less liquid environment, and the information contained in the price trends less reliable as a guide to the underlying asset.

Piranhanoia's picture

The tsunami approaches.  For now it is just invisible rip tides dragging everything out to sea. It crosses the Atlantic draining banks, and like a hurricane does, it will hammer the caribbean and turn the paper banks to sand. Faith in something as inherently corrupt as a CDS based upon a sovereigh nation that bought crap paper and now relies on that as a major percentage of their assets may not be such a great idea going forward.

Bob's picture

Banning CDS?  Just another example of dot gov crippling the innovative invisible hand of the market.  So sad. 

How we gonna get our vig?  In advance, I mean. 

This will impair free and efficient price finding for gamma and zeta risk. 

Okay: /sarc

ZackAttack's picture

I don't care who makes or loses money on swaps as long as they aren't ever transferred to the public balance sheet.  Treat it like any other insurance product and let the states determine whether there's adequate capital backing the writer.

Michelle's picture

Hell, let's not ban anything, we are such an immoral society today anyway, everything should go and we should all be happy that we have free air to breathe, too.

If Wall Street creates it, we should be proud, no, HONORED, that such innovation exists within our borders. We should bow down to the Wall Street gods and allow them carte blanche on anything they want to do, no matter the outcome. We should bless the ability to even banter about these corrupt markets for what productivity may come otherwise?

Give me a freaking break, I say we stop TOLERATING and start DEMANDING that "The Markets" don't CONTROL US! The politicians are already owned and so are we.



jm's picture

Interesting post.

I agree with you about moving trading onto exchanges.  But the exchanges then need to net against each other or you face the same problems as without any exchange clearing at all.   And this process presents a nightmare.

Also you seem to imply that a desirable aim is to cut CDS dealer margins.  There's not much to cut out of index trading, and I'm not sure how much volume there will be on single names at least in the short-term future. 

Also, there is a lot of institutional money that drops money into CDX.IG until OTR issuance comes around. It's not all hedge funds and prop that use CDS.