Sovereign CDS – still not dead yet, regulations helping | FT Alphaville

Sovereign CDS – still not dead yet, regulations helping

It’s the data you’ve all been waiting for. It’s from DTCC and it covers sovereign CDS. Has the market shrunk, given that whatever is going on in Greece hasn’t yet met the definition of a credit event?

Erm, turns out it hasn’t. Here’s the data on what the total outstanding contracts are as of Friday:

Out of respect for Zero Hedge and to give a fuller picture, we’ve put the gross notionals in too. FT Alphaville has previously explained the difference between gross and net notionals. The crux of it being that when your counterparties are alive and collateralising, net is more relevant. And when they’re dead and liquidating, it’s your gross position facing that counterparty that you care about, and how that affects your overall net position versus everyone who’s still standing.

What can be seen in the above table is that over the last month, there has been a marked increased demand for CDS referencing Germany while those for Italy, Spain and Ireland have seen a decline. However, these declines aren’t exactly worth the “sovereign CDS are bereft of life” type headlines.

Coming at it from an angle of sheer activity, there was a dip last over last week, but nothing that hasn’t been seen before and transaction volumes can differ substantially from one week to the next anyway. This table is an aggregate of all single-name activity, for both sovereigns and corporates:

Why might this be? For one, CDS are still a hedge in the mark-to-market sense. As FT Alphaville has mentioned before, this is the same market that sees value in a derivative that references debt that doesn’t exist, e.g. CDS on Saudi Arabia. Sometimes it’s less about the cash and more about the accounting. DVA gains — whereby banks booked gains on a deterioration of their own creditworthiness — have been a case in point this quarter.

That said, we have a feeling that investment and credit committees around the world are going to do some soul-searching about the political risks around CDS — not just because of Greece, but also because of the naked short ban.

While said committees are making up their mind about whether to use CDS as an asset class and/or hedging tool, Isda will be polling its members to see how they want to deal with the latest niggle (and this is a market with a long history of niggles and a track record of responding to them with various protocols and modifications to the documentation that the industry uses).

But what about banks subject to Basel regulations? These incentivise them to use CDS to hedge their counterparty exposures when those counterparties are sovereigns. How much of this market is down to demand from CVA desks that manage these exposures to government entities? From November’s issue of Risk:

CVA desks have become bigger players in sovereign and other CDS markets over the past few years – one market participant suggests 25% of demand for protection relates to CVA hedging – and dealers expect this growth to continue in the run-up to the implementation of Basel III’s capital requirement in 2013.

OK, it’s just one guy, but nonetheless, we ♥ numbers. Do said CVA desks care whether the contracts don’t trigger?

“The market’s not dead because we still need it for marking our Basel III requirements,” says Ian Harris, head of CVA trading at Credit Suisse in London. “The question is whether it is a good tool for doing that, and whether banking regulation should be tied to it. It’s creating a kind of fictitious demand independent of the economic value.

This is echoed by Jeremy Vice, London-based head of CVA trading at UniCredit. “From the capital perspective there’s no change – under Basel III you have to buy CDSs if you want to mitigate your CVA capital. Even in the extreme case where any restructuring is designed so contracts don’t trigger, there will still be demand from CVA desks if capital mitigation is a goal. To the extent sovereign CDS pricing adjusts to reflect their ineffectiveness as a hedge, then perversely that regulatory capital mitigation would be cheaper,” he says.

So, let’s get this straight.. right now, CVA desks are driving something like a quarter of the demand for sovereign CDS. Doing this is in part a regulatory arbitrage for them such that more hedging means a lower capital requirement. To the extent that other market participants think that such CDS are now worth less because of politicians’ attempts at financially engineering around a credit event for Greece, that will cause spreads to move tighter, making the arb cheaper. Go Team Basel III!!

Of course, it doesn’t end there. We haven’t even mentioned the death spiral whereby sovereign CDS widen out and CVA desks are obliged to buy more, driving spreads higher… That’s one crowded trade all pointing in the same direction. Keep this in mind the next time spreads are widening out and politicians howl about the evil speculators that are exacerbating moves in the market (psst they may just be CVA desks following Basel regulations).

It’s also worth reiterating that nearly all sovereigns do not post collateral, but do demand it themselves — the dreaded one-way CSA. Banks have been trying to encourage sovereigns to start posting collateral so that they wouldn’t have to hedge against with CDS quite so much.

And lastly, we draw your attention to the idiosyncrasy defence, courtesy of IFR:

One person close to the Basel Committee said there had not been in-depth regulatory discussions around sovereign CDS use as a hedge, but added: “The Greece situation is a bit unique and whether one can generalise from this experience to all CVA and counterparty credit risk hedging is not necessarily valid. What it does show is that with any hedge there is event and basis risk, and that argues for prudence.”

Not an ex-product then. At least not yet. Looks like the credit event trigger is looking a bit closer too.. In the words of the Andrews Sisters, “Hold tight, hold tight, hold tight, hold tight, Foo-ra-de-ack-a-sa-ki”.

Ok, we don’t get that last bit either, but nothing makes much sense these days anyway.

Related links:
Why the Greek CDS market is OK – Felix Salmon, Reuters
We Need to Talk About Sovereign Credit Default Swaps – Nick Dunbar