C.M.O. 3.9.2009
Credit Market Overview
March 9, 2009
These are historic times for many reasons; The U.S.A. elected its first Black President and the economy is experiencing a contraction that brings to mind some of the most severe in this Nation’s existence.
Additionally a majority of investors have lost confidence in the markets. One of the most often sited reasons for this are the issues connected with the Credit Default Swap (CDS) market. It has been blamed for causing the downturn in stocks, the collapsing of the global economic system and if you look hard enough, the common cold.
Today the Intercontinental Exchange (ICE) begins operating a clearing house for CDS contracts after receiving approval from the SEC on Friday and the Federal Reserve last Wednesday.
I believe this step is a positive one for the CDS market and to the extent it helps bring back confidence a positive step for the marketplace in general.
There has been much written regarding the evil loosed by trading Credit Default Swaps. A lot of what I have read seems to have come more from emotion than fact and some, while eloquently written, was not authored by anyone with practical market experience.
I have purposely stayed out of the fray as it seemed best to ignore the static. In this weeks Barron’s Michael Santoli, whom I would expect to be knowledgeable in things market related, made the statement that the only people that should be allowed to trade CDS contracts are the people who own the bonds.
Having traded in the equity, fixed income and futures markets, the first two in both cash and derivatives and the third being a derivative itself I am a bit flummoxed as to why everyone is trying to reinvent the wheel with regard to CDS trading.
As a counter to Mr. Santoli’s point, there are two designations for participants in the futures market: hedger and speculator. Where would the hedgers lay off their risk if the market did not allow speculators to take the other side of the trade? The hedgers are people involved with the physical commodity, farmers, miners, processors and are in the market to reduce risk not increase it.
The speculators are in the market to profit from price movement regardless of direction and take the risk the hedgers are trying to alleviate. To prevent the speculators from controlling the price movement there are limits placed on the number of contracts they are allowed to hold.
The equity market too has controls in place to prevent misdeeds. Anyone owning more than 5% of a company is required to report his holdings to the SEC within 10 days of the “acquisition event”.
The equity and futures markets are deep, liquid, vibrant, healthy markets and while those with mal-intent might wish the rules did not exist it is a long term positive for the rest of us that they do.
The CDS market was extremely profitable for the dealer community for many years because of the products opaqueness and lack of regulation. Having worked at a firm that provided inter-dealer liquidity in the CDS market it was not unusual to see bid/offer spreads between the sell side firms 1/10th of the bid/offer spreads shown to buy side customers. This created an incentive to keep things as they were and make as much money as possible.
Given the products profitability it is not a stretch to think that anytime unpleasant noises were heard from those proposing regulation a call was made to the lobbyists in Washington and the game continued.
AIG is the poster child for what was wrong with the CDS market but here too it was not the product but more that AIG’s Financial Products subsidiary wrote billions of dollars of CDS contracts without hedging any of its exposure. Is that a problem with the product or with risk management at AIG?
As is clearly evident at this point the CDS market needs to be regulated to some extent as the major participants have proven through their actions, that they are unable to police themselves.
Before we put manacles on top of the handcuffs however let’s take a look at what regulations are in place in other markets that are operating efficiently and use those as a model for the CDS market.
Enjoy the weekend.
Jim Delaney
March 9, 2009
These are historic times for many reasons; The U.S.A. elected its first Black President and the economy is experiencing a contraction that brings to mind some of the most severe in this Nation’s existence.
Additionally a majority of investors have lost confidence in the markets. One of the most often sited reasons for this are the issues connected with the Credit Default Swap (CDS) market. It has been blamed for causing the downturn in stocks, the collapsing of the global economic system and if you look hard enough, the common cold.
Today the Intercontinental Exchange (ICE) begins operating a clearing house for CDS contracts after receiving approval from the SEC on Friday and the Federal Reserve last Wednesday.
I believe this step is a positive one for the CDS market and to the extent it helps bring back confidence a positive step for the marketplace in general.
There has been much written regarding the evil loosed by trading Credit Default Swaps. A lot of what I have read seems to have come more from emotion than fact and some, while eloquently written, was not authored by anyone with practical market experience.
I have purposely stayed out of the fray as it seemed best to ignore the static. In this weeks Barron’s Michael Santoli, whom I would expect to be knowledgeable in things market related, made the statement that the only people that should be allowed to trade CDS contracts are the people who own the bonds.
Having traded in the equity, fixed income and futures markets, the first two in both cash and derivatives and the third being a derivative itself I am a bit flummoxed as to why everyone is trying to reinvent the wheel with regard to CDS trading.
As a counter to Mr. Santoli’s point, there are two designations for participants in the futures market: hedger and speculator. Where would the hedgers lay off their risk if the market did not allow speculators to take the other side of the trade? The hedgers are people involved with the physical commodity, farmers, miners, processors and are in the market to reduce risk not increase it.
The speculators are in the market to profit from price movement regardless of direction and take the risk the hedgers are trying to alleviate. To prevent the speculators from controlling the price movement there are limits placed on the number of contracts they are allowed to hold.
The equity market too has controls in place to prevent misdeeds. Anyone owning more than 5% of a company is required to report his holdings to the SEC within 10 days of the “acquisition event”.
The equity and futures markets are deep, liquid, vibrant, healthy markets and while those with mal-intent might wish the rules did not exist it is a long term positive for the rest of us that they do.
The CDS market was extremely profitable for the dealer community for many years because of the products opaqueness and lack of regulation. Having worked at a firm that provided inter-dealer liquidity in the CDS market it was not unusual to see bid/offer spreads between the sell side firms 1/10th of the bid/offer spreads shown to buy side customers. This created an incentive to keep things as they were and make as much money as possible.
Given the products profitability it is not a stretch to think that anytime unpleasant noises were heard from those proposing regulation a call was made to the lobbyists in Washington and the game continued.
AIG is the poster child for what was wrong with the CDS market but here too it was not the product but more that AIG’s Financial Products subsidiary wrote billions of dollars of CDS contracts without hedging any of its exposure. Is that a problem with the product or with risk management at AIG?
As is clearly evident at this point the CDS market needs to be regulated to some extent as the major participants have proven through their actions, that they are unable to police themselves.
Before we put manacles on top of the handcuffs however let’s take a look at what regulations are in place in other markets that are operating efficiently and use those as a model for the CDS market.
Enjoy the weekend.
Jim Delaney
Labels: CDS, correlation, credit, equity
posted by Jim Delaney at
3:05 AM
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