It’s a well understood fact that credit derivatives markets are primarily dealer-to-dealer. We do, however, hear that there are clients, or “end-users”, hiding somewhere. The Bank of International Settlements’ Quarterly Review, out on Monday, invites us to take a closer look.
Introducing Nicholas Vause, who put the section of the Review together, and his informative graphs (click to enlarge):
What this shows you is the aggregate position of the 62 dealers that went into the BIS statistics is that of a net buyer of protection when facing actual “end users”, and the quantum of this position has increased over the last two reporting periods, for the most part.
The one exception is for hedge funds, to which dealers sell increasing amounts of protection on a net basis, but we’ll get back to that in a bit. It’s worth expanding on the acronym-fest before discussing further:
BSD (woeful choice of acronym) – brokers and dealers that don’t report statistics to BIS.
IFGC - insurance, reinsurance, financial guarantee firms, and pension funds.
SPV - you probably don’t need a reminder, but: “legal entities that are established for the sole purpose of carrying out single transactions, such as in the context of asset securitisation through the issuance of asset-backed and mortgage-backed securities.”
NFI - this group of non-financial customers tends to be comprised of corporations and governments.
OFC - not a NFI, and also meeting none of the other definitions above. Mainly mutual funds.
Now, it’s logical that BSDs and some IFGCs are net protection sellers to dealers — since CDS provide another way for these institutions to go long a credit and earn income from it in the form of premium payments.
The fact that OFCs, NFIs and the pension funds in IFGCs are also, on a net basis, using CDS to go long is interesting. Call us sentimental, but part of us would have hoped that pension funds and mutual funds would be using CDS to hedge on a net basis rather than just pile on more risk. But hell, what’s a manager to do in such a low yield environment?
Finally, those love ‘em, hate ‘em hedge funds are net short to dealers, presumably betting on the untimely doom of corporates and sovereigns. Put a slightly different way, if we do experience a wave of defaults, expect more and more payouts from banks to hedgies (though the banks may be hedged themselves of course).
Usual disclaimer that we don’t know what exact role CDS are playing for any of the above actors, e.g. whether there might be basis trades with bonds and so forth.
But anyway, who’s winning?
Perhaps predictably, dealers are winning — in the sense that they are net protection buyers in a widening spread environment — though we’re not jumping to the conclusion that they were über clever to be on the right side of the trade. In any case they should just be making markets here for the most part. The size of positive mark can be seen by looking at the red diamonds in chart on the left. Dealers are, however, losing against hedge funds.
The chart on the right just shows how having a lot of trades facing the same counterparty results in lots of netting.
Here’s the chart that is the star of the section though:
This chart again looks at the aggregate net notional position of dealers versus non-major-dealer counterparties. A few interesting things:
- ABS and MBS exposures are very low. Two thumbs up, or two snaps up in a circle, if you so prefer.
- Hedge funds and smaller dealers/brokers are the most likely end-users to be involved in sovereign CDS.
- The large “multiple sector” component is likely comprised of credit indices, like the iTraxx Europe, CDX.NA.IG, etc, but also tranches, and more customised basket trades.
- Curious how much of the exposure is non-rated…
The BIS ties these last two together to reach the following conclusion:
A key insight from the enhanced BIS credit derivatives data is that non-rated multi-name credit risk sourced from multiple sectors has been transferred from derivatives dealers to IFGCs, SPVs and OFCs. Such risk transfers are likely to have been generated by basket CDS, synthetic CDOs or CDS index tranches. These types of CDS can be difficult to value and have experienced significant price jumps in the past. To the extent that such risks remain, they appear to have been passed on from the banking sector to parts of the non-bank financial sector often known as shadow banks.
On the one hand, the problem almost certainly isn’t as big as it used to be. On the other, it seems unwise to scoff at hundreds of billions of valuation risk in the non-bank financial sector, particularly in an environment of reduced liquidity.
A final thing about the above graph is that these exposures are not about to vanish overnight — very few have maturities of under a year.
More on maturities in a post to follow…
Related links:
New Report Features CDS And Shadow Banking, Is Not In The Sunday Times – Dealbreaker (Matt Levine beat us to the punch, feign surprise)
Hedge Funds Transfer Credit Risk to Derivatives Dealers - Lawbitrage
BIStimates of the over-the-counter derivatives market - FT Alphaville