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

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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