Default-Swap Traders Needed
There's a big business opportunity sitting almost untouched in Asia. As with any great deal, it's not without risks, but the profits and benefits to the market could outweigh potential troubles.
Asian banks and exchanges are missing the chance to become more active in the credit default-swap market, just when investors need it most. Soured debts are increasing in the region, and investors have few options to protect their credit exposure to troubled companies, leaving them to short the stock and spread the pain to minority shareholders.
In case banks on this side of the world lack an incentive, they need only look at their Western counterparts. Bloomberg News reported Tuesday that Wells Fargo, not primarily known for aggressive investment banking, plans to increase its CDS trading. The lender's focus will be on the least liquid and most underserved corner of the market -- insurance against defaults by companies.
Wells Fargo is plugging a huge gap. In December, 25 investment firms including BlackRock and Pacific Investment Management Co. announced plans to voluntarily clear the instruments to help revive the shrinking market.
While swaps with a notional value of $1.7 trillion had traded by March 4, up 35 percent from the same period last year, the market is still pretty illiquid, especially for contracts that insure against a single corporation missing payments. Most of the trading happens in indexes.
After the U.S. insurer AIG was brought to its knees during the global financial crisis, partly because of its exposure to default swaps, the number of entities willing to sell the derivatives dwindled, and so did the trades themselves. That was in spite of a movement by the International Swaps and Derivatives Association to simplify the product and to have more of it cleared by central counterparties, which reduces the risk that if one traders fails -- as happened with Lehman Brothers -- all the others will be left holding the bag.
Credit default swaps are perhaps the most effective way to hedge against losses on credit exposure to a company, industry or country. They should have grown in the past eight years as the amount of bonds outstanding worldwide reached records -- with Asia in the forefront. Yet, they have dwindled.
The Bank for International Settlements said in its quarterly review published Sunday that shorting of bank stocks to hedge potential losses from their subordinated bonds may help explain the rout in the asset class in the first two months of the year. The strategy is common among hedge funds in Asia exposed to high-yield credit. Traditional fixed-income mutual funds, in which smaller investors without the clout to participate in hedge funds can invest, are usually barred from trading stock, leaving them naked in a selloff. A more liquid CDS market would plug that gap and reduce the pain for smaller stock and bond fund investors.
If regional exchanges such as those of Singapore and Hong Kong entered the business as central counterparties, they would also find a much sought-after new source of revenues as stock trading volumes drop.
The Hong Kong exchange had already taken a deeper plunge into commodities with its acquisition of the London Metal Exchange, which helped boost 2015 earnings. Singapore's bourse is trying to buy London's Baltic Exchange to emulate its neighbor's success in shipping. Both moves were driven by dropping revenues in stock trading.
As defaults in Asia increase, the demand for insurance will, too. More providers will be needed and they are more likely to surface if there are strong central counterparties. The biggest exchanges have a profit incentive to foster growth. There will be hiccups and the occasional breakdown, as is bound to happen with derivatives. The benefits of more activity, however, probably outweigh the risks.
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