Last week, Bloomberg reported that BlackRock, the world’s biggest asset manager, is leading a push to revive a type of derivative known as the single-name credit default swap. Readers may remember that such CDSs were blamed for exacerbating the financial crisis of 2008. So why, one might ask, would anyone want to revive this particular corner of the credit market?
Here's a rundown.
Meet the single-name CDS.
Cast your mind back to 1994. Ace of Base topped the charts, Forrest Gump was about to sweep the Oscars, and banks had a little risk management problem. In the days before the invention of the CDS, a bank that had made a loan to, say, Exxon could face losses if the company were to default. Yet such a bank had no way of hedging, or offsetting, that default risk without outright selling the loan it had just made. Enter the single-name credit default swap.
In the 1990s, JPMorgan bankers came up with the idea of selling an insurance-like contract that could help protect banks and other big investors from exactly this kind of credit risk. As The J.P. Morgan Guide to Credit Derivatives later put it: "Consider a corporate bond, which represents a bundle of risks, including perhaps duration, convexity, callability, and credit risk (constituting both the risk of default and the risk of volatility in credit spreads). If the only way to adjust credit risk is to buy or sell that bond, and consequently affect positioning across the entire bundle of risks, there is a clear inefficiency. Fixed income derivatives introduced the ability to manage duration, convexity, and callability independently of bond positions; credit derivatives complete the process by allowing the independent management of default or credit spread risk."
So what happened after that?
Credit derivatives proved wildly popular—perhaps a little too popular. A market that had originally been dominated by banks seeking to hedge the risk in their corporate books was soon expanded to traders who saw the opportunity to use CDSs as a way to speculate on the future direction of the market. By the mid-2000s, banks and traders were also using CDSs to hedge and bet on the future performance of various mortgage securities. When the housing bubble burst and the value of mortgage securities began to drop, investors who had written CDS protection on mortgage-related investments suddenly found themselves on the hook for hundreds of billions of dollars’ worth of payouts on the CDS contracts they had sold, with mega-insurer AIG standing out as the starkest example. AIG was eventually bailed out by the U.S. government and CDSs’ reputation as "financial weapons of mass destruction" was apparently sealed.
After 2008, the popularity of single-name CDSs dropped dramatically and new regulation effectively reduced the ability of big banks to deal in the products. While a big swath of credit derivatives, including CDSs tied to indexes, were mandated for central clearing—a process intended to reduce the probability of a CDS player going bust and then roiling the wider markets—single-name CDSs remained "over the counter" transactions largely negotiated privately between two parties. Net wagers in single-name swaps have subsequently dropped to $686 billion from more than $1.58 trillion in late 2008, when the Depository Trust & Clearing Corp. (DTCC) first started reporting positions in the market.
So why does BlackRock want to revive the market now?
It's been more than six years since the worst of the financial crisis and a lot has happened in the world of credit since then. For a start, half a decade of ultralow interest rates has encouraged investors to buy whatever fixed-income securities they can find and then hold on to them tightly. That, along with some new regulation, has arguably contributed to a stark decline in so-called liquidity in the corporate bond market at the exact same time that the market has exploded in size and scale. By most accounts, trading bonds in large sizes has become more difficult and more expensive just as the overall market for U.S. corporate debt has jumped to $7.8 trillion currently from $5.4 trillion outstanding in late 2008, according to Securities Industry and Financial Markets Association data.
In an environment where it's difficult to buy and sell cash bonds, derivatives tied to such debt can be a handy substitution. And to some extent, investors have already been turning to credit derivatives as a way to make up for the lack of liquidity in the overall bond market. But—crucially—they've mostly been using CDS tied to a group, or index, of companies as opposed to single-name CDSs tied to just one particular corporate name. Net wagers on the most active CDS contract tied to an index of North American investment-grade companies (known as the "CDX") have jumped more than 37 percent in the past two years to $90.7 billion, DTCC data show, at the same time that single-name CDS trading has fallen off a cliff.
Yet trading CDS indexes can be problematic because you lose the thing that first vaulted CDSs into popularity anyway: precision. Using an index as an overlay to hedge means that you've purchased insurance on a big portfolio of credits as opposed to the handful of bonds that you are really worried about. It's an imperfect hedge. That imperfect hedge might work so long as interest rates remain low, and corporate defaults across the board are suppressed, but once rates rise and defaults are back on the table, investors may want a more targeted risk-management tool.
Is there any other reason BlackRock might be interested in reviving single-name CDSs?
Absolutely. We mentioned that years of low interest rates have sparked an intense scrum for assets with a discernible shred of yield. Using CDSs has the potential added bonus of allowing big investors to juice their returns by deploying what is known in Wall Street parlance as leverage. Without a functioning CDS market, big investors would have to boost returns by lending out their bonds (a strategy that plenty of them have been using already). With a CDS trade, you post a relatively small amount of cash as margin and can use the rest of your money to make other investments—thereby boosting your returns, according to some market participants.
By most accounts, investors have already been turning to a veritable smorgasbord of alternative and more exotic types of derivatives—such as total return swaps and options on CDS indexes—as a way of both hedging and boosting leverage. Data on the use of such derivatives are more difficult to come by, but Citigroup analysts have estimated that $1.4 trillion of CDS index "swaptions," for instance, exchanged hands in 2014, compared with $573 billion in 2013. A report published last week by Bank of America Merrill Lynch said that $400 million of total return swaps tied to the iBoxx derivatives index were trading hands per month. Neither total return swaps nor CDS index options are yet required to be cleared.
What are other people saying about this?
Peter Tchir, head of macro strategy at Brean Capital, is downright enthusiastic about what he describes as the "grassroots" effort currently under way to revive a single-name CDS industry previously thought to be on its deathbed. In a note published over the weekend, he says: "The push to improve the product is being driven by a broad group of investors and dealers, rather than the cabal that sometimes seems to drive the CDS agenda." Perhaps most important, he notes that the industry is finally waking up to the competition facing CDSs from other types of credit derivative products. "The days of CDX indices being the only beta game in town are gone," Tchir writes. "There is real competition for the time, energy, and resources of the buy-side, and while the CDS side was to some extent living off of its legacy, hard work and effort has been put into creating viable alternatives."
How should I feel about this?
Cautiously optimistic? It wouldn't be a terrible thing if CDSs return to their original roots as a credit risk management tool. To revive the market, BlackRock is also aiming to push single-name CDSs into central clearing, which would hopefully avoid an AIG-style situation in the future. Moreover, the return of the single-name CDS market with clearing and suitable oversight could in theory provide a viable alternative to investors who have so far been turning to a bevy of alternative derivatives and credit products. Data on the use of total return swaps and swaptions, for instance, are by no means complete, and they have been multiplying largely without the kind of regulatory supervision that is attached to CDSs.
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