Tropical Storm

Sometimes a story comes along that is so emphatically off-base that it makes you just shake your head and wonder. And sometimes it makes you write a riposte.

A recent opinion piece in the American Banker is a prime example. The main thrust of the article is that the credit default swaps (CDS) market is troubled because it does not function like the equity or options market ‒ you can’t get a CDS quote “on a website like Yahoo or Google.”


It’s hard to believe this is a serious point of discussion. Of course these markets function differently. From June 7 to June 13, 2012, between 7 and 8 million trades on NASDAQ-listed issues were executed each day. On the NYSE Euronext, about 1.6 million trades in European equities have been executed on average per day over the course of 2012.

In the CDS market, by contrast, about 6,400 contracts are executed each day. Globally. On all reference entities. It would take 1,172 trading days for CDS trading volumes to equal one day’s worth of trading volume for NASDAQ-listed issues. It would take 250 trading days for CDS trading to equal one day’s worth of European equity trading on the NYSE Euronext.

Anyone who knows anything about the CDS market realizes that CDS volume is relatively small, and that trading in most reference entities is not very liquid. A brief look at the DTCC data, for example, reveals that in a recent week (of May 15), the number of reference entities that traded more than 20 CDS contracts per day was 27 out of more than 800. In other words, on the order of 97% of CDS reference entities traded less than 20 contracts per day during that week.

Despite this public data, the article posits that:

“That leads us to perhaps the most saddening question of those posed above: Has there been tacit cooperation among market participants and data vendors to preserve the status quo in the CDS mud pit?

Yes. Perhaps the most egregious form of cooperation is the effort to preserve the impression that there is active trading in a large number of reference names when in fact there is not. I know this having reviewed trading volume reported by the DTCC for all CDS reference names, including U.S. banks, sovereign issuers, and regional and local governments.”

“Preserve the impression?” This is ludicrous. Market participants have been telling anyone who will listen about the dynamics of CDS trading volume.

What could possibly account for this gap in understanding? Particularly given that it comes from a well-respected firm (that is lucky enough to be based in Hawaii)?

Could it be that the signals of CDS trading are sometimes misinterpreted? Or that they conflict with the firm’s own default probability solutions? Witness this:

“Breathless reporters or rating agencies claim ‘Dell’s CDS widen 42%’ when, in fact, there were only 9.6 trades of any kind per day and 1.75 non-dealer trades in Dell during the week ended May 25, according to the DTCC.

Reporters need a story, and the CDS mud pit provides material. Rating agencies need a product that is not a rating, and the CDS mud pit provides one.”

We agree that the trading volume of the CDS market needs to be better understood. And we agree that CDS price signals need to be viewed with the proper perspective. CDS do not aim to predict the probability of default, but they do accurately depict the cost of hedging against default. That is their intended purpose…and it is widely known. Even in Honolulu.


Any Given Sunday….

Another Sunday, another New York Times column on “you guessed it – derivatives.” This one purports to show how derivatives are costing mass transit riders higher fares and lower services. The story goes like this:

“Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers – and the issuers, in turn, agreed to make fixed-rate payments to bond holders.”

At which point we need to stop to point out that the example is actually wrong.  We think what the column meant to say was that “the issuers, in turn, agreed to make fixed-rate payments to the bank.” This would be a classic example of an issuer doing a floating rate bond issuance and then swapping into a fixed rate to lock in its exposure. But we digress:

“These swaps were supposed to save the public some money. And, for a while, they did.”

Oh, maybe this won’t turn out so badly?  But then:

“Then the financial crisis hit – and rates went south and stayed there. Now issuers are paying bond holders above-market rates as high as 6 percent. In return, they are collecting a pittance from banks – typically 0.5 percent to 1 percent.”

To recap: the swaps saved issuers money. They effectively lowered the issuers’ interest payments. This remains true today. But now apparently those savings are not enough. Given the level of interest rates today, the column posits that muni issuers could be saving even more.

Well, if that’s the case, why don’t the states and municipalities refinance their debt and issue new bonds with lower interest rates? The problem, according to the column, is that:

“Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni.  The price, in the form of a termination fee, can be enormous.”

Banks do charge fees for terminating swaps, based on the market value (or replacement cost) of those transactions. Lower rates could and probably did increase the value of those contracts.

But how is this different from what issuers would face if they had just issued fixed-rate debt in the first place (with no swap)? They would have garnered none of the interest expense savings. And they would have to compensate bondholders in the form of a premium if they now wished to refinance higher–rate debt with lower-rate debt. (That’s why there’s generally a premium paid by issuers who issue callable debt.)

The article then goes on to say:

“Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers.”

It’s not clear what exactly is meant by “deals like these,” but here are a few facts. All of the top companies – and thousands of large, mid-sized and smaller firms – in the US and around the world use interest rate swaps. This suggests that corporations frequently seek to lock in their financing costs.

So now we get to the crux of the column:

 “…the banks are taking advantage of our generosity by gouging us on these toxic deals.”

What, exactly, is toxic about helping municipalities manage their interest rate risk and save money?

A Gathering in Boston

A flurry of stories over the past week have reported (including this one in the FT) on an interesting meeting recently held in Boston that was attended by leading buy-side and sell-side market participants. The meeting apparently focused on liquidity and electronic trading in the bond markets.

“But, oddly, participants at last month’s meeting in Boston were not especially gung-ho about electronic trading. Some of the largest asset managers do not believe that transparency is automatically their friend. If they want to shift a big block of bonds, a skilful dealer might be able to do it without moving the market. This is more difficult if you’re sending an order electronically for the world to see.

Unlike equities, debt instruments are not homogenous. There is not always a ready market with buyers and sellers. Banks, as responsible (and often reluctant) market makers will take an asset and hold it for some time.”

Now, as noted, the meeting was about bonds, and not OTC derivatives, and most of it does not concern us. But the parallels between some of the issues faced by both markets are strikingly familiar.

What are those parallels?

The buy-side – asset managers and others – want and need flexibility in executing their transactions. This usually means ensuring they have the right combination of price, speed and anonymity, depending on the particular firm and the particular transaction. The market-making function of banks provides this flexibility. Restrictions that would limit either the ability of firms to receive or the ability of market-makers to provide that flexibility are a real cause for concern for all market participants.

As we have stated, and shown in previous research, the OTC derivatives markets are very price competitive and dealers play an important market-making role in them. Derivatives users have access to prices from a variety of dealers in a variety of ways. Proposed changes to a system that works – and works well – need to do more than preserve the status quo (or why do them in the first place); they need to add incremental value.