CDS Futures – Can this pig sing?

The $24.7 trillion Credit Default Swap market[i] is one of the last untapped exchange-traded derivatives markets.  The question remains is the market ripe for a CDS futures contract, or as Mark Twain famously put it, “Never Try To Teach A Pig To Sing.  It Wastes Your Time And Annoys The Pig.”  So, can this pig finally sing?

The InterContinentalExchange (ICE) believes it is the right time and launched a CDS Futures contract (Ticker: WIG) on June 17, 2013.  The contract is based on Markit’s liquid CDX.NA.IG 5Y series.  The contract is complementary to the current “on the run” OTC traded CDX.NA.IG 5Y swap as the futures contract is priced on the theoretical value of the next CDX.NA.IG series.  This “When Issued” structure creates an option valued on the next CDS series.  In other words, it is a vehicle to hedge near term macro-economic credit risk (as opposed to immediate term credit risk with an OTC swap).

The chart below shows trading in the Sep 13 CDS future.  Although less than impressive, it is important to look back to the introduction on US Treasury futures in 1976/1977 as a point of reference.

Image

 

Initially, Treasury futures (and a sister GNMA future) were not a success.  When they finally launched, volumes were only a few hundred contracts per day. 

Low volume on this new contract is not a surprise, given the “when issued” impact of the CDS future and the effect on final settlement.  Many counterparties may be on the sidelines until the new contract goes through the first final settlement.

Is Dodd-Frank & EMIR Equal To The End of Britton Woods?

OTC swaps and specifically CDS’ do not have a “Nixon Shock/end of gold standard” fracture with currency and inflationary volatility.  These waves of volatility served as the “tipping point” for currency and interest rate futures.  Like the currency markets of the early 1970’s, OTC CDS swaps are a custom forward market.  Thus, the CDS future is in many ways similar to currency futures as both vehicles create standard models for the exchange of counterparty risk.

As market forces will not drive the adoption of a CDS future, will regulation and regulatory pressures do it?  Title VII of Dodd Frank changed the execution, clearing, and capital structures of the CDS swap market.  Let’s take a look at changes in the OTC market as compared to the ICE futures.  First and foremost, margin and transaction costs are now highest for customized products and lowest for standardized exchange-traded products.

Category

Bilateral Swaps

OTC Cleared

Futures

Liquidity

Liquid

Highest Liquidity

Illiquid

Margin

Highest, TBD

Higher

Lowest

Margin Calculations

10-day VaR

5-day VaR

2-day VaR

Transaction Costs

Basel III Capital Requirements

FCM and associated LSOC costs

FCM Margin/Cost of Carry

Termination/Compression

Intra-party and Compression

Intra-party and Compression

Exchange

Valuation and Reporting

Intra-party

Intra-party  & SEF

Exchange

 

Dodd Frank, EMIR, and Basel III changed the rules but internal momentum is still hard to overcome.  Any OTC CDS futures development must be co-dependent with the existing OTC swap market.  Exchanges are the ultimate networked organization where liquidity begets liquidity.  Therefore, for the futures to gain liquidity, the following Tipping Point actions must occur simultaneously.

  1.  Outstanding rules and margins for non-cleared bi-lateral swaps must be completed and implemented.  This includes implementation of Category 3 participants in centralized swap clearing.
  2. Banks must decide (or be convinced as part of increased CDS market scrutiny) to utilize CDS futures.  This benefits banks on the Basel III capital requirements side and the overall CDS market in terms of transparency.
  3. For parties interested in hedging credit risk on a macro-level, substitution value of the CDS future must be greater than the disincentive of a new, riskier product.  In other words, the perceived opportunity cost of trading CDS futures is very high.

 June 2013 was a volatile period.  Volatility was not just related to central bank intervention and QEIII discussions.  Operational volatility in the OTC market was the result of new rules and margins for Category 1 and 2 participants.  In hindsight, given the confusion around central clearing, market participants are still trying to adjust to the fluidity of new swap rules rather than eyeing a complementary credit risk solution. 

In this context, it is important to not underestimate the gravitational pull of the existing swap market.  Traders, banks, and counterparties have underlying relationships with swap desks (and not necessarily with a futures counterpart).  Transacting with two desks lowers your relative importance in a market that depends on relationships. 

So, can this pig sing?  Well, we don’t know yet.  Once the music director finishes writing the final score and the band makes an entrance, then we’ll know whether this little piggy has a market or this little piggy gets none.


[i] 2012 Gross Market Value, According to ISDA and BIS

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