Via the Bank of England’s Quarterly Bulletin, here’s an interesting observation on the sovereign CDS market — one that should be required reading for regulators, traders and the media alike.
It focuses on activities of counterparty valuation adjustment (CVA) desks and how they influence — sometimes quite strongly — the price of sovereign CDS.
Before we look at that, here’s a quick introduction to CVA desks, and how they go about their business:
A commercial bank’s CVA desk centralises the institution’s control of counterparty risks by managing counterparty exposures incurred by other parts of the bank. For example, a CVA desk typically manages the counterparty risk resulting from a derivative transaction with another financial institution (such as entering an interest rate swap agreement).
CVA desks’ hedging of derivatives exposures In a derivative transaction, a bank may incur a loss if its counterparty defaults. Specifically, if the bank’s derivative position has a positive marked-to-market (MTM) value (calculated for the remaining life of the trade) when the counterparty defaults this is the bank’s ‘expected positive exposure’. These potential losses are asymmetric. If the value of a bank’s derivative position increases (ie the bank is likely to be owed money by its counterparty), the potential loss in the event of default of the counterparty will rise. In contrast, if the value of the bank’s derivative position falls such that it is more likely to owe its counterparty when the contract matures then the potential loss on the transaction is zero.
Having aggregated the risks, CVA desks often buy CDS contracts to gain protection against counterparty default – something which the BoE says they have been doing more and more of, because of the eurozone debt crisis.
And the result has been to push prices away from levels reflecting the underlying probability of default, apparently (emphasis FT Alphaville’s):
Specifically, CVA desks of banks with large uncollateralised foreign exchange and interest rate swap positions with supranational or sovereign counterparties have reportedly been actively hedging those positions in sovereign CDS markets. For example, for dealers that have agreed to pay euros to counterparties and receive dollars, a depreciation in the euro will result in a MTM profit and hence a counterparty exposure that needs to be managed…
…given the relative illiquidity of sovereign CDS markets a sharp increase in demand from active investors can bid up the cost of sovereign CDS protection. CVA desks have come to account for a large proportion of trading in the sovereign CDS market and so their hedging activity has reportedly been a factor pushing prices away from levels solely reflecting the underlying probability of sovereign default.
Something worth remembering. The spread on five-year Greece CDS reached 798.83 bps on Tuesday, according to CMA Datavision — implying a 48 per cent cumulative probability of default.
Related links:
The phantom securities which haunt the BoE, quantified – FT Alphaville
Another CDS curve inverts — Spain – FT Alphaville
How sovereign bonds should be rated – FT Alphaville