This In Practice piece gives a practitioner’s perspective on the article “Interconnectedness in the CDS Market,” by Mila Getmansky, Giulio Girardi, and Craig Lewis, published in the July/August 2016 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Amidst the alphabet soup of derivative contracts, we now know that credit default swaps (CDSs) are capable of having a systemic financial impact equivalent to that of an exploding rocket. But this pejorative label is also not wholly deserved, not least because a CDS can also be a useful risk management tool.
CDSs are a multi-trillion-dollar market that came into being in 1994 as a utilitarian business solution. A CDS transfers credit risk exposure from the balance sheet of the contract buyer to a credit protection seller. The authors provide a deeper understanding of how, and why, the market players use CDSs and analyse their various motivations.
The world of derivative products is divided into two spheres: over the counter (OTC) and centralised clearing counterparty (CCP). OTC derivatives are bilateral legal contracts between buyer and seller. The bilateral element means that the product buyer is exposed to the credit risk of the seller, which is referred to as “counterparty risk.” For example, an OTC buyer who purchased a CDS from Lehman Brothers to get protection against the occurrence of a specified credit event in Brazil suddenly discovered when Lehman Brothers went bankrupt in 2008 that this protection was useless.
In contrast, a buyer who had purchased a similar CDS via a CCP was unaffected by Lehman Brothers’ bankruptcy. Centralised clearing alters the constitution of the bilateral element by removing the credit exposure of buyers and sellers to one another and replacing it with a credit exposure to the CCP.
Studying the network of CDS relationships in the United States in the OTC and CCP realms to better understand the interconnectedness between dealers and nondealers in CDSs can help practitioners assess the stability of the CDS market and navigate risks of market contagion.
How Do the Authors Tackle This Issue?
The authors focus on the commercial dynamics and interconnectivity of the CDS market. They also provide a succinct account of the structure and evolution of that market. They place their study in the context of the recent regulatory efforts to rehabilitate the CDS market, which imposed mandatory CCP clearing and new margin requirements for uncleared OTC derivatives.
The authors evaluate transaction data for single-name CDSs traded during 2012 excluding all solely non-US transactions. They examine five separate daily record snapshots of the positions data submitted to the Trade Information Warehouse (TIW) of the Depository Trust and Clearing Corporation (DTCC). Interestingly, the study window covers the period after the Volker Rule was proposed but before it was formally adopted. The Volcker Rule prohibits large bank holding companies from proprietary trading. During the study window, many banks withdrew from proprietary trading in anticipation of the adoption of the rule.
The authors estimate that their data sample represents 82.6% of the global single-name CDS market and 45.4% of the total CDS market. They break down the participants into dealers and nondealer — the latter comprising pension funds, asset managers, hedge funds, banks, and nonfinancial companies.
The study is based on a network-based approach that uses multiple measures of connectedness between dealers and nondealers. Although the data analysis and market intelligence are finite, they provide a valuable map of the links between the players and products.
Crucially, the authors explain how, and why, the issue of CDS systemic risk concentration, in the realms of both the OTC and CCP markets, remains, and why uncertainty, in terms of both systemic risk and legal risk, is still an issue. In particular, they articulate how the transaction data interconnect with the legal contract framework for all CDSs, whether OTC or CCP. They also explain the architecture that the International Swaps and Derivatives Association (ISDA), the derivatives lobby group, has developed in response to the Volker Rule.
What Are the Findings?
The authors slice through the spaghetti of derivatives regulation to assess valuable “how and why” dynamics of CDS market activity. They identify the types of protection in demand and how widely the risks are distributed. Using quarterly positions data, they find that, on average, both dealers and nondealers tend to have a small net risk exposure to CDS contracts relative to their gross exposures. But although firms may have limited net exposures, counterparty risk is determined by gross exposures.
The density of counterparty relationships that the authors identify is of particular importance. They sort the top buyers and sellers into seven tiers using a trade activity scale and then tabulate the number of counterparties with which each entity trades CDSs. They pinpoint insightful network linkages, despite the fact that the vast majority of counterparties have no direct bilateral links. For example, they link the 2012 trading volumes in CDS trades purchased on the sovereign debt of Spain, Italy, and Greece in response to the eurozone debt crisis of 2011.
The interconnection insights tabulated by the authors make obvious why a CDS, which is ostensibly a sensible financial tool, can still very quickly convert into something altogether different. For example, the study demonstrates how during the eurozone debt crisis, CDS buyers opted to simultaneously purchase credit protection and manage counterparty risk.
What Are the Implications for Investors and Investment Professionals?
The authors identify factors that make the CDS markets both robust and vulnerable. They demonstrate the extent to which CDS players have direct and indirect bilateral links. The direct link is counterparty risk. This risk still exists in both the OTC and CCP realms. More than 70% of all CDS contracts are bought or sold by the top 10 counterparties. Additionally, risks come from the gross amounts, not the net amounts. These elements give rise to indirect links that buyer end users may be unaware of.
Even the simple realisation that such linkages exist offers practitioners a better understanding of the extent to which their own counterparties are also transferring risk. The data analysis vividly illustrates buy-side and sell-side action dynamics by reference to the Volker Rule, the Dodd–Frank Act, and systemically important financial institutions.
In a nutshell, this study speaks directly to systemic risk, one of the biggest issues financial markets face. At a minimum, it informs practitioners about due diligence questions they should pose when buying credit protection.