Markit credit analyst Lisa Pollack investigates why 2007 is still haunting a number of CDS index products when it comes to off-the-run volumes.
According to ISDA, there were $62,000bn of credit default swaps (CDS) at the end of 2007. What exactly is this number though? First, it’s gross, not net. If one desk at a dealer is a buyer of $10m of CDS protection and another desk at the same dealer is a seller of $10m of CDS protection, the dealer as a whole has a net position of zero. In order to be perfectly fungible, the two CDS contracts have to have the same attributes, meaning reference entity, tier, maturity, currency, and restructuring clause.
This sort of redundancy of CDS contracts only gets bigger when you zoom out to look across dealers. For example, Dealer A buys $10m from Dealer B, who buys $10m from Dealer C, who buys $10m from Dealer A. If they realised they’d gone full circle, they could tear up all the contracts on the count of three, right? They’d probably feel all the better for it too, being less interconnected and having a reduced operational burden.
Starting from the summer of 2008, the process of tearing up redundant contracts got underway in earnest, as part of an industry wide initiative. This process is called trade compression. Markit is one such provider of this service for single name contracts, under which over $7,000bn worth of trades have been torn up.
Clearing also results in the removal of redundant trades, since all participants face the clearinghouse — this is one of the advantages of the clearing model. With compression and clearing, as well as a more general decrease in volumes seen across the market over the last few years, the gross notional outstanding of CDS is now $26,000bn. This figure is current as of December 17, 2010 and weekly updates are publicly available from DTCC here. The table below breaks this number down further:
Single names are for CDS that reference a single entity, e.g. Spain or Banco Santander; indices are tradable products that reference a group of entities, e.g. Markit iTraxx Europe or Markit CDX.NA.IG; and tranches reference certain slices of those indices with different risk profiles. While some tranches are standardised, in that they have set structures with standard attachment and detachment points referencing standard indices such as the Markit iTraxx, other tranches are bespoke, which is to say that they were tailor made to a given client’s specifications.
An issue that deserves attention, which was also discussed in a note by Citi a couple of weeks ago, is that a lot of bespoke and standard tranches that were printed from 2005 and 2007 are still out there. Furthermore, they are being actively hedged. Meaning that some considerable portion of the CDS market is being fuelled by these hedging needs. Bespoke tranches can be hedged with standard tranches, indices, and/or single names. Standard tranches can be hedged with indices and single names. In 2005, some dealers even tried hedging standard tranches with other standard tranches. That particular episode didn’t end especially well.
So the question again is this: how much of the CDS market is driven by these hedging needs? And given that much of the old tranche volume will be coming off the books in the next few years (also pointed out by Citi), what does this mean for the CDS market?
It’s challenging to estimate how much of the single-name CDS market is driven by this need for hedging, and with tranches it’s also difficult. However, the story told by indices is telling. The below two graphs show two investment grade indices. The series are of notional volumes traded, divided up by on-the-run and off-the-run indices. The aggregated on-the-run and off-the-run data are published daily and are publicly available here, courtesy of a joint effort by Markit and DTCC. When the number of trades on a given day is fewer than 5, the data are not published.
Before we dig down here, couple of things that deserve an explanation. First, sorry about the cut off on the second graph. The data point that’s off the chart is from December 14 when the notional traded on Markit iTraxx Europe off-the-run indices was €103bn. It seems that someone may have been cleaning house that day. Secondly, the most recent index is referred to as ‘on-the-run’. The on-the-run index for Markit iTraxx Europe is currently Series 14 and for the Markit CDX.NA.IG it’s Series 15. There are new series every six months. All the series that aren’t the most recent, i.e. on-the-run, are referred to instead as ‘off-the-run’.
The principle of rolling to new series is to have the most relevant reference entities in a given index. For example, the CDX.NA.IG Series 4 contained the following investment grade companies (it was on-the-run in March 2005): CIT, Fannie, Freddie, Lear Corp, and WaMu. Needless to say, these reference entities are not in more recent incarnations of the CDX.NA.IG (IG = Investment Grade). Information on index constituents available here.
Now, back to the graphs. As one would expect, the liquidity is concentrated in the most recent, and therefore most relevant, on-the-run index. Also noted is the volatility in the notional traded per day. But then, the real stunner — the vast majority of the off-the-run volume is concentrated in a single series, the Series 9 for both the iTraxx Europe and CDX.NA.IG. So much so, that on several days, all of the off-the-run volume was due to the 9s.
The missing piece of the puzzle is that the last time a given iTraxx/CDX series had any significant volume traded in their related (hence standard) tranches was the Series 9s. The Series 9s were on-the-run when printing in bespoke and standard tranches was still active. While issuance was likely past the peak, it was still soldiering away in the spring of 2007.
And so it is that the market is frozen in time. Dealers continue to use these off-the-run indices, in considerable volumes, to hedge the positions on their balance sheets. For many desks, this no doubt represents a state of wind-down mode.
What are the consequences here?
One can surmise that in certain areas of the CDS market, liquidity will decrease with the reduced demand for certain instruments. But with clearing, other instruments may see their liquidity increase. One thing is for sure, that $62,000bn number will remain a thing of the past. Where the market will stand when wind-down mode is truly over remains to be seen and will no doubt depend greatly on the outcome of initiatives like clearing as well as regulatory developments.
Related links:
Guest post: Speaking volumes with credit indices – FT Alphaville
Desert(ing) CDS – FT Alphaville