Italy – bite-sized CDS, taste the volatility | FT Alphaville

Italy – bite-sized CDS, taste the volatility

The Markit iTraxx SovX CEEMEA contains a basket of 15 sovereigns from Central and Eastern Europe as well as the Middle East. Italy’s CDS spread is now wider than all but one of them – Ukraine.

Looking at the Markit CDX.EM, only Argentina, and once again the Ukraine, can offer chunkier spreads. Outer limits, indeed.

It is, of course, not just Italy that has moved significantly wider. As the chart below shows, Spain had been wider than its benchmark index for some time. Italy, meanwhile, punched through the index and then punched through Spain. And of course no such chart would be complete these days without the core EFSF guarantors, France and Germany.

According to DTCC data, these four sovereigns have $83bn of net notional outstanding, which equates to 6.9 per cent of all single-name CDS positions.  To be even more clear about how big they are in the market, they comprise the Top 5 of all single-names, with Brazil snuggled between constitutional-deficit-limiting twins Spain and Germany. Very, umm, cosy.

A bonus feature of having such a wide spread, as Italy now has, is usually a drop in liquidity.  Just ask Greece, Portugal, or Ireland.  Bid ask spreads move out as dealers require more compensation to take on riskier positions.

It should come as no surprise then that Italy has indeed seen an increase in its average bid ask spread, moving from around 5bps to more like 10bps from the middle of July, according to data from Markit.  CDS referencing Spain have a similar bid ask, while Germany and France have stayed steady at around 3bps and 4bps respectively, despite seeing their own spreads widen out.

Another interesting thing that’s happened for all four sovereigns is that the average trade size has gone down, as can be seen in the chart below.

The activity data include terminations as well as new trades, and can also include upsizes and downsizes of the notional of existing trades.  In other words, when looking at these data, you have to consider the possibility that some of these are simply little tweaks going on to positions that were already on the books.

The amount of trading activity in any given week is hugely volatile.  The busiest week for Italy CDS in 2011 so far saw 867 trades, the quietest saw 80, and the average has been 285.

The general trend in 2011 has been increased activity. France and Italy saw the most notable increases, but in all cases the uptick in trade count has been more dramatic than that of the notional amount increases. Hence the decrease in the trade sizes.

Why the tendency for trade sizes to be smaller again?

For Italy, it’s fairly obvious and the message is in the increased bid ask spread. It’s simply more costly, in risk terms, to run a book on a wider credit, not to mention the difficult trading environment more generally.

On the end-user side, FT Alphaville hears that this is mostly a question of adjustments to legacy positions. Remember that some investors were actually using sovereign CDS before the crisis.

Along similar lines, corporates may adjust existing positions too, if they want to hedge their business activities against a slowdown in the respective economies where the companies that they deal with are located.  Of course, some may be taking the plunge for the first time with bigger notionals. The data are just averages after all.

And then, to leave the most interesting for last… there is the CVA feedback loop. This is where increased CDS spread volatility leads to additional hedging by CVA desks, which leads to increased volatility, which leads to additional hedging by CVA desks, ad infinitum and beyond.

By the by, that volatility input into CVA is something that’s baked into Basel III and will kick in in 2013. Remember that the next time a politician complains about CDS having a negative impact on the costs at which sovereigns fund themselves.

Related links:
Rococo risk hedging, a sovereign-bank tale - FT Alphaville
Volatility blamed on lower inventories – IFR
Contagion at the core – FT Alphaville