CBOE vs CDS | FT Alphaville


A hat tip to Bloomberg for alerting us (again) to another request from the CBOE to the SEC.

Having recently asked for permission to list same-day options, the CBOE is now seeking to alter the terms under which credit default options (like credit default swaps but standardized, exchange-traded, and cleared by the OCC) can be traded.

From the CBOE’s filing (emphasis ours):

The Exchange received approval to list and trade Credit Default Options and Credit Default Basket Options (collectively “Credit Options”) in 2007, and is planning to re-launch these products. In connection with the Exchange’s planned re-launching of Credit Options, the Exchange will be introducing contracts that have a payout that is less than $100,000. In addition, the Exchange would like to: (1) change the quoting convention for Credit Default Options, (2) change the minimum price variation for Credit Option, and (3) designate a single applicable Credit Event for Credit Options.

More details in the filing, but the gist is that the CBOE wants to bring more flexibility to the way these options trade than was initially granted — in other words, to make the options resemble CDS just a bit more.

The CBOE obviously reasoned that now, between the passage of Dodd-Frank and the writing of new derivatives rules by the SEC and CFTC, was a good time to re-launch this product and position itself ahead of the new regulations.

There are some logical questions about how well this is going to work. Writes Bloomberg (our emphasis):

In its filing with the SEC, CBOE didn’t say whether market makers would facilitate trading in the credit-default options. New York-based Jane Street Specialists LLC was the market maker for the earlier product.

“The biggest challenge is to build liquidity and get market participants to trade the instruments,” Nybo said. “Until you do that, the marketplace simply won’t develop.”

CBOE also proposed altering rules about how the contracts settle and what constitutes a credit event, which determines whether the product has a payout. CBOE plans to change the increment by which quotes in credit options can move to allow for bids and offers at more prices. The exchange told the SEC that “more pricing points” would decrease the spread, or difference between bid and offer prices, which would benefit investors by enabling them to sell a contract for more money and buy at a cheaper price.

There could be a long way to go before the CFTC and SEC finish writing their new regulations. July 2011 as the deadline for when the process has to be completed, though CFTC chairman Gary Gensler just said that he’d like to have some of the proposals written by the winter and made available for public comment.

Until we do have the new rules, it will be hard to know how trading in CDS themselves will be affected — much less how credit default options can compete against CDS in areas such as pricing and transparency.

So we’ll just have to wait and see.

Related links:
CBOE Plans to Challenge CDS Market – Bloomberg
Derivatives reform: now what – FT Alphaville
Same day options — no thanks – FT Alphaville