The ‘Big Bang’ accelerated evolutionary market changes to the CDS market and the impact of so many changes hitting simultaneously promises unintended consequences. As these global changes continue to take hold, there is bad news and good news within the credit markets, explains Joe Kohanik of Linedata Services.
The credit crisis of 2008 has created a “Big Bang” Post Mortem. Years of natural market evolution has been crammed into the past twelve months. These changes are still being handed down, sometimes with haste and often times with government intervention. The ‘Big Bang’ accelerated evolutionary market changes to the CDS market and the impact of so many changes hitting simultaneously promises unintended consequences. As these global changes continue to take hold, there is bad news and good news within the credit markets:
– The bad news, global speculative-grade default rates are currently running at 12%, up from 2.8% a year ago, the global commercial real estate market is on a global down turn and municipalities in the U.S. are staring at budget deficits in excess of $500B for 2010.
– The good news, investors world-wide will have credit default swaps as a tool to mitigate the myriad of risks associated with their investment horizons and goals. During this prolonged period of market dislocation new credit risks become public each day and buy and sell side participants require the need to hedge, or dare I say speculate, on their bets.
Market consistencies represent good news for the market
With standardization being the mantra of 2009, let’s look at a few key areas of change that are standard across all global regions.
Credit default swaps now trade with fixed coupons as opposed to negotiated rates on each deal. This change is modeled after the more standardized and more liquid CDS index market. Having fixed coupons makes single name credit default swaps more fungible and provides more standardization to pricing and valuation. Additionally, it allows for more fluid trade compression.
Another global standard change involves effective dates for credit event and succession event processing. This change addresses “stub” risk. In the old world order, credit protection begins on T+1. Suppose an investor sells protection and then 5 days later buys an offsetting position. In this example, there is a “stub” period of 5 days where the investor is short. This “stub” risk would remain until the first trade matures. By creating a standard date for the existence of protection, the new world order eliminates stub risk.
But market differences remain
With standardization also comes the need for certain jurisdictional areas to manage credit default swaps in slightly different ways. From a jurisdictional perspective, the world is divided into five regions, The Americas, Asia ex-Japan, Australia-New Zealand, EMEA (Europe, Middle East and Africa), and Japan. Within these regions there are subtle nuances that cater to the specific local market needs while maintaining the goal of standardized contracts.
As an example, let’s compare Europe to the U.S. Europe has fixed coupons of 25, 100, 500, 1000 bps, while the U.S. has coupons of 100 and 500 bps. Further, the U.S. has dropped restructuring as an event, while Europe has kept restructuring perhaps due to the fact that there are unique legal differences between the many countries that make up this region.
What is in store over the next two years in the swaps market?
During the credit crisis, investors recognized the large operational risks that credit default swaps brought with credit protection. I’ll offer three projections:
1. As investment management firms “do more with less” human capital, there will be increased focus on straight-through-processing in the middle and back office specifically for CDS and more broadly, for over-the-counter securities.
2. Firms will revise internal processing of collateral management, seeking more automation as they eke out as much leverage as they can from their capital base.
3. And lastly, governments around the globe will surely continue to meddle in areas of investment management where their qualifications are slim, at best. No doubt they will haggle over laws and passing legislation that in the end will be either not enough or too much….leaving room for new regulation and legislation in 2012 and beyond!
* In previous columns, Joe evaluated major trends in both the money market industry and foreign exchange market.