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.


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