“Over time we’ve seen a secular increase in the use of CDS and a decrease in the use of bonds as a trading tool,” he said. “Last year we saw bonds being placed at new issue more as a buy-and-hold investment as fund managers found their ability to trade out of bond positions in secondary markets much more limited.”
That’s Niall Cameron, the global head of credit trading at HSBC, being quoted by Chris Whittall of IFR. The article provides anecdotal evidence that actual clients (non-dealers) might be getting more involved in the market lately. Like so:
Cameron pointed to a marked increase last year in the number of real-money investors that would use CDS as overlays on bonds portfolios – whether it is to take a more bearish view or to put some excess cash to work – instead of just relying on the secondary bond markets.
There’s a little part of FT Alphaville that thinks, “well, he would say that, wouldn’t he?” Mo’ clients = mo’ money. That said, there’s probably something to the argument that scarily illiquid bond markets have meant increased flows into credit derivatives that can, for certain corporate and sovereigns referenced, be more liquid.
The IFR piece seems to indicate that peripheral sovereigns have been a case in point:
The CDS market also became the fallback option for many traders during the most tumultuous periods of 2011. When volatility spiked in August, traders reported that much of the cash market in Europe remained frozen, particularly in peripheral sovereign debt, forcing end-users to turn to CDS to execute trades in any size.
It’ll be interesting then to see what effect the naked sovereign shorting ban, that’s coming in towards the end of the year, is going to have on such trading.
As a reminder, the rules were drafted in such a way that: (a) “naked” was defined such as to mean “no long exposure to the underlying at all”, (b) individual regulators can choose to suspend the ban if they think it’s harmful to their markets. If the academic evidence is anything to go by, the CDS market can exacerbate moves in cash markets, particularly for more distressed credits (think CVA feedback loop of death, etc).
On the bond side of things, it’s not just a liquidity story, but also a bank funding and regulatory one:
Financing bond inventories is expensive thanks to a combination of the current crisis raising banks’ funding costs, and regulators introducing more stringent liquidity rules. Risk-weighted assets becoming costlier to hold under Basel III also disincentives long bond positions.
Some things are so obvious… once someone else says them. Thanks, Chris. We now owe him two beers.
Lastly, to throw some data into the mix, here’s some CDS volume data from DTCC (click to expand):
The table at the top is one year ago, and the table below shows the position at the end of 2011. The health warning is that these are gross notionals. That means that it’s impossible to get all that much info out of the upper left hand entry in the table — dealer-to-dealer notionals could go down because of processes that tear-up redundant contracts and clearing, not just from reduced activity. In other words, the dealer-to-dealer positions are likely to be much bigger than the table would allude to, they’re just managed in a more operationally efficient way, in part because they have to be with that much going on.
Take it as an approximation though that dealer to non-dealer notionals and trade counts have gone up substantially over the course of a year. Non-dealer volumes have been near to these levels before — at the end of 2010 the lower left corner was $3.9tr and the upper right was $3.7tr. It’ll be an interesting trend to watch, and the end-2011 BIS statistics (that give a more detailed breakdown of user groups) should give further indications once those are out.
And the next time you meet your financial advisor, maybe you can ask her to check whether your pension fund has CDS in their mandate, (and let us know what they tell you)…
Related links:
CDS benefits from cash market freeze - IFR
Meet the credit derivative “end-users” – FT Alphaville