What proponents don’t get about credit default swaps

In the Atlantic Charles Davi tries to argue that critics of credit default swaps simply don’t understand the market.  However, his arguments don’t show that he has a clear understanding of the market himself.

With the CDS market, we have a market-based measure of the credit quality of a wide variety of debt instruments outstanding for a given issuer. This makes the credit quality of an issuer more transparent, not less.

This is incorrect, because every CDS price necessarily includes not just a premium for protection against default by the underlying, but also some premium for the counterparty risk inherent in buying protection on derivative markets.  (The existence of negative basis trades where the CDS price is below the rate paid by the bond probably reflects the fact that the CDS market — for the limited group of people who are allowed to trade these high denomination products — is indeed more liquid than the bond market.  Note that as far as I am aware, there is neither empirical evidence, nor a theoretic argument that supports the view that more liquid markets produce better prices.)  As noted in earlier posts, the only circumstance in which an over the counter derivative does not involve counterparty risk is in the theoretic example where the derivative is written by a monetary authority.

Because CDS prices necessarily confound a premium for protection against default with a premium for counterparty risk, it’s hard to understand the foundation of the argument that CDS prices give a better measure of credit quality than a model based only on the bond yields themselves — which will as rule include no credit risk premia for parties other than the issuer.

However, even if we were to grant the argument that CDS prices give a superior measure of default risk, then that would immediately indicate that price disclosure in the CDS market must be improved.  While Davi claims that

the level of publicly available information from the CDS market is on par with that from the corporate bond market

as a small scale trader, I can assure you that this statement is incorrect.  I can access intraday corporate bond bids and offers whenever markets are open.  Davi links to the only public CDS pricing data that I know of — and this only gives end-of-day prices after the market is closed.  If Davi’s argument that CDS prices are “better” than bond prices is correct then the bond market is seriously biased against small traders.

In other words, if CDS price information is as valuable as claimed, then it is inexcusable to restrict access to intraday price and quantity information to insiders like the market making banks and their biggest clients.  In short, if the CDS market produces tradable price information, then as Gensler argued it’s time for CDS to trade on exchanges so that intraday prices and quantities can be made public in real time and everybody who trades bonds can benefit from the information created by this market.

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10 thoughts on “What proponents don’t get about credit default swaps”

  1. The fact that derivatives are novated (i.e. all parties must agree to any change in counterparties) makes it clear that CDS countracts are strictly bilateral. Since these are bilateral transactions, I don’t understand how you have managed to establish the “uniformity” of prices empirically.

    1. You are conflating issues here. Collateral levels are counterparty specific. Prices are not. So when a trade gets novated, if new counterparty is a lower quality credit, the remaining party will want to renegotiate the terms of the collateral agreement (credit support agreement, or CSA for short). As such, novation (bilateral consent) is required if you want to assign your trade to a new CP.

      But this has no impact on the price of the transaction. That is why the market reports ONE price for the same contract. E.g., a 5 year CDS on GE will cost the same for Hedge Fund X and Hedge Fund Y in terms of upfront amount and quarterly spread. Where the terms of the trades will differ is in the collateral agreement.

      1. So are you claiming that the market makers post their prices publicly and that any counterparty that meets specific legal criteria has the right to buy at that price. My understanding of the over the counter market is that each hedge fund contacts each market maker separately and gets a quote. While any given market maker may choose to offer the same price terms to two different counterparties (for example a long-time client and a newbie) but there is no obligation whatsoever in OTC markets to offer two different counterparties the same price. While Markit reports prices at which trades are taking place, it’s not my understanding that in OTC markets those prices are necessarily available to any one who wants them.

        If your view of the market is correct, where are the rules for uniform pricing written down and who enforces them?

  2. I am saying one thing, and you are expanding it for no reason.

    You said CDS market prices include counterparty risk and therefore aren’t useful for assessing overall credit risk. That is not true, as I demonstrated above. That’s one issue and that’s the end of it.

    Now, that said, you are bringing up new distinct issues, such as “obligations” to give everyone the same price. While there is no obligation for any dealer to give the same price to two funds, the reason that one fund might get a better price than another has NOTHING TO DO WITH CP RISK. Dealers can deal with CP risk through collateral and have NO INCENTIVE to price CP risk through the upfront/premium payments. In fact, if their books have the same trade priced differently, it makes it harder for them to net down their books.

    1. If you acknowledge that OTC markets are designed such that two funds may be offered different prices, I don’t understand how you can be certain that prices don’t include a counterparty premium.

      I would argue that even retail traders sometimes choose to pay a counterparty premium, by for example paying high fees to trade via Vanguard or Fidelity instead of E-trade — precisely because they want to avoid the inconvenience caused by bankruptcy. As long as OTC markets are structured the way they are and as long as there is no big database of trades so we can establish some solid facts about what’s going on in the market, I don’t think it’s possible for you to prove your claim that there is no counterparty risk premium built into the price of CDS.

      1. I work in the market. You are arguing that market practice something other than that which I have observed. You are free to do that, but I don’t know why would. Sure, different parties can get different prices for the same trade. But the quotes given have nothing to do with CP risk.

    2. I don’t know how someone who “works in the market” would observe whether counterparty risk premia are being charged. That would require empirical analysis of data from many if not most counterparties. You have a sample limited to your own work experience. In that sample you admit that you observe different prices charged to different counterparties. I am just saying that one of the reason different prices are charged is because of counterparty risk. This is a reflection of my own experience of the world and the fact that I know that I am willing to pay more to a more reliable counterparty — and I’m pretty sure the average hedge fund is willing to do the same.

    3. For example if you are willing to acknowledge that a market maker will offer a better price to a long-time hedge fund client than to a brand new hedge fund, why would you assume that the difference does not represent a premium for counterparty risk. This to me a classic case of differentiating prices based on the counterparty risk of a known versus an unknown client.

      Perhaps what you mean be counterparty risk and what I mean by counterparty risk are very different things.

  3. People, market makers will charge different counterparties different prices. You agree on that. The amount of collateral required reflects the perceived counterparty risk. You agree on that also. Typically, price differences are related to ‘managing’ client relationships. Of course I’ll look after my long-term customer.

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