Next up in our look at the potential impact of blockchain technology on the derivatives market are credit default swaps. There is much to unpack here, so this section will be divided in several parts: the first entry will give an overview of what the instrument is and why its market is so important. The second will talk about blockchain work already going on in the space. Later posts will discuss recent scandals and new legislation in more detail, and how regulatory changes point to blockchain roadblocks and opportunities.
The credit default swap (CDS) emerged in the 1990s, rose to notoriety in the 2008 crash, and was one of the protagonists of the hit 2015 movie “The Big Short”. Few financial instruments get to star in a film, but the CDS has a talent for superficial deception: it masquerades as a humdrum insurance play, but in reality, it can be a volatile risk investment.
Although the CDS market is nowhere near as large as other derivatives such as foreign exchange and interest rate swaps, it has attracted more than its proportional share of scrutiny and criticism. To understand why, let’s take a look at how they work.
What is a CDS?
Stripping it down to the basics, a credit default swap allows a holder of a bond (corporate or sovereign) to hedge the exposure by promising a payout (usually a pre-established percentage of the face value of the bond) if the issuer defaults on its debt. So, if you hold a debt instrument issued by a corporation which then goes bankrupt, your bond is almost worthless but you offset that with the payout from the CDS.
This hedge can be especially useful if the bond is relatively illiquid, which would make it difficult to sell if the market starts to get nervous. The possibility of hedging can also lower borrowing costs by reducing the risk of a security.
It’s important to note that a CDS is not actually tied to a certain bond – it just references it.
And you don’t have to hold the referenced obligation to buy a CDS. You could just do so for speculation if you believe that things will go badly for an obligation issuer. Or, if you’re convinced that a company is solid with no risk of default, you could write a CDS – someone will pay you a purchase price and periodic interest, and you will only have to make a payout if you’re wrong.
Given current volumes (greater than the those of the underlying obligations), it seems that speculation is the main motive these days for purchasing CDSs. However, limits are starting to be imposed. For instance, the systemic risk inherent in betting on government defaults (and possibly doing what you can to nudge them along) led the European Union to ban the purchase of “naked” CDSs (held without the underlying security) for sovereign bonds.
It’s not just debt default that could trigger a payout. Any “credit event” could suffice, depending on the contract, such as a debt rating downgrade, a restructuring or a currency redenomination (although new standards exempt the debt of members of the EU switching to a new sovereign currency, unless the creditworthiness declines).
And, CDSs don’t always have to be based on a specific debt security. They can also reference several bonds at once.
As if all that wasn’t complicated enough, you can also buy and sell a “credit default swaps index”, which allows you to hedge your entire bond portfolio. These derivatives are standardised financial instruments, with relatively high liquidity.
Apparently trading volumes on credit derivative indices has shot up recently, indicating unease about the US debt and interest rates. In fact, the CDS market is becoming so sophisticated that it is increasingly read as a barometer for market outlook.
Where do they trade?
Originally, all CDSs traded on over-the-counter (OTC) markets. However, the lack of control over the accumulation of heavily leveraged positions did serious damage in 2008 when unexpected payouts came due.
The 2008 financial crisis triggered a re-examining of regulation and oversight, which culminated in the Dodd-Frank Act of 2010, the most sweeping reform since the Glass-Steagall act almost 80 years earlier. One aspect, the Volcker Rule, mandated the separation of proprietary trading and commercial banking (to ensure that customers’ deposits were not used for trading for the bank’s own profit). This meant that many large CDS traders exited the market, further reducing liquidity.
Title VII of the Dodd-Frank Act, which came into effect in 2013, ruled that all CDS index derivatives (not single-entity CDS, or those that reference a narrow range of borrowers, since they generally have low trading volumes) had to be centrally cleared – that is, settlement had to be carried out via a central clearing house, which stands between the buyer and seller and ensures liquidity and delivery. It also mandated more reporting and increased collateral requirements.
The clause also requires all cleared credit derivatives to be traded on a regulated exchange, or a swap execution facility (a registered trading platform with more oversight than the OTC market).
Europe has followed a similar path. The European Market Infrastructure Regulation (EMIR), introduced in 2015, mandates the reporting of derivative contracts to a trade repository, and requires the central clearing of CDS indices and certain euro-based corporate credit default swaps. This is to be gradually implemented over 2017-18.
The global net volume has shrunk considerably since 2008 (when it reached a whopping $60tn), but is still a considerable $10tn a year.
According to the Bank of International Settlements, the majority of CDSs are still OTC-traded. This is likely to see a substantial shift in the short term. In 2015, a group of large asset managers, including Citadel, BlackRock and Anchorage, pledged that they would centrally clear their own single name CDS trades, with a view to increasing volume and lowering costs (in addition to having lower liquidity, non-cleared single-name CDSs carry heavy capital charges).
A significant change for the market is that the Act requires all swaps – even uncleared and OTC-traded ones – to be registered with a swap data repository (SDR).
The US and Europe account for about 90% of the global CDS market, with Latin America following behind with about 5%. China recently started trading CDSs – given the relatively fragile state of its bond market, this source could become significant in the near future.
Who regulates them?
This is a complicated area, with overlap, gaps and quite a bit of confusion, even within jurisdictions.
In the US, the two main regulatory bodies when it comes to financial instruments are the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).
The SEC has regulatory authority of “security-based swaps”, including CDSs that reference a particular bond or a narrow range. The CFTC regulates credit swaps based on indices. Both organizations jointly cover credit swaps that have a commodity component (such as foreign exchange). Also, both organizations jointly make decisions regarding jurisdiction, data recording and intermediaries. (I’ll be writing about this more soon, as it’s a fascinating mess.)
In Europe, the framework appears to be simpler: the CDS market is regulated by the European Commission (EC). The European Markets Securities Authority (ESMA) makes regulatory proposals for the EC’s consideration, and can set fines in certain circumstances.
The International Swaps and Derivatives Association (ISDA) sets global standards.
So, here we have a systemically important yet relatively opaque financial market, with complicated regulation and siloed data. The complexity alone, with a relative lack of standards and an increasingly international impact, makes the need for streamlining clear – even though the consequences are not.
More investigation of the regulation of the CDS market is warranted, as is a detailed understanding of recent rulings and fines in the sector, but this post is long enough as it is. However, the recent surge in interest in CDS trading makes clarity on the lessons learned and the way forward especially important.
In the next post in the series, we’ll look at some of the ongoing work on blockchain implementations in this market. As we’ll see, the progress is slow, but – given the complexity – that is both understandable and desirable.