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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Jun 6

Written by: Donald van Deventer
6/6/2012 1:53 AM 

The recent sight of the mighty JPMorgan Chase, wallowing in a credit default swap position from which it cannot exit, raises many questions.  One of the key questions is a particularly simple one: is the arena for credit default swap trading a market place or a mud pit?  In this blog, we sadly conclude that the answer is “mud pit” and outline some of the very many steps that are necessary for credit default swap arena to become a market place.  Without these reforms, the CDS mud pit is likely to suffer the same fate as collateralized debt obligation-total irrelevance.

JPMorgan’s May 8, 2012 announcement of $2 billion in losses turned the spotlight on the arena for credit default swaps, a security that doesn’t hold up well under bright lights.  How can a sophisticated market participant like JPMorgan Chase end up suffering such discomfort and illiquidity in the U.S. financial markets, once the pride and joy of U.S. financial services companies?  We explain that in this post, debating the question “Is the arena for credit default swaps a market place or a mud pit?”  We focus on single name credit default swaps, not the credit default swap index market in which JPMorgan has suffered its losses.  The reason for our focus is also simple: the CDS index market is built on the foundation of the single name CDS market. If the single name CDS market is a mud pit, so is the index market.

What do we mean when we ask if the CDS market is a mud pit?  We are in essence asking the following questions:

  • Is there a transparent and open transmission of traded prices, bids and offereds in real time by reference name like there is for common stocks and options?
  • Is there reliable reporting of trade volume in real time like there is for common stocks and options?
  • Is there sufficient competition in the market to prevent market manipulation by a concentrated set of dealers, like there is for common stocks?
  • If the market is highly concentrated, is there sufficient regulatory scrutiny to prevent rampant market manipulation?
  • Is there sufficient regulatory scrutiny to prevent CDS trading on inside information?

Sadly, the answer to all of these questions is no. The unfortunate answer to another key question is “yes”--that question is “Has there been tacit cooperation among market participants and data vendors to preserve the status quo in the CDS mud pit?”

We briefly deal with each of these questions in turn.

Is there a transparent and open transmission of traded prices, bids and offereds in real time by reference name like there is for common stocks and options?

No. In spite of changes in reporting by the Depository Trust & Clearing Corporation (www.dtcc.com) in recent years, the single name CDS bids, offereds, and traded prices are tightly controlled by a small cadre of dealers, market data vendors, and DTCC itself.  The data is not freely available on a website like Yahoo or Google.  While one broker who distributes CDS data does time stamp bids, offereds and trades in its data service, they are the exception, not the rule, and they see a relatively small market share of total activity.  The primary product offered by the largest CDS data vendor does not distinguish between bids, offereds, and traded prices.  Moreover, the data service typically lists CDS spreads for 2,000 corporates and sovereigns even though there have never been more than 1,000 reference names traded in a given week since DTCC began reporting trade volume (but not bids, offereds, or traded prices) since the week ended July 16, 2010.

Is there reliable reporting of trade volume in real time like there is for common stocks and options?

No. DTCC has this information, but it makes trade volume available on a weekly basis with a 3 business day lag, starting with the week ended July 16, 2010.  Through January, 2012, the terms of use agreement for that volume data made it illegal for me to tell you how many single name CDS were traded in JPMorgan because of this phrase:

“You agree to treat any Report containing data on a specific entity, rather than aggregate position or transaction activity or other aggregate data, as confidential, or, if you are a regulator or governmental entity, in accordance with any statutory confidentiality requirements applicable to you.”

Fortunately, since January, this phrase has been removed. 

Is there sufficient competition in the market to prevent market manipulation by a concentrated set of dealers, like there is for common stocks?

No. In a recent blog, using the standard measures of market concentration by the Department of Justice and volume data from the Office of the Comptroller of the Currency, we showed that the market for credit default swaps has been “highly concentrated” since its inception.  For the full text, see this link:

http://www.kamakuraco.com/Blog/tabid/231/EntryId/371/The-Credit-Default-Swap-Market-and-Anti-Trust-Considerations.aspx

The European Commission announced on April 29, 2011 that it was launching two anti-trust investigations into the CDS market:
http://europa.eu/rapid/pressReleasesAction.do?reference=IP/11/509&format=HTML&aged=0&language=EN&guiLanguage=en

If the market is highly concentrated, is there sufficient regulatory scrutiny to prevent rampant market manipulation?

No. In fact, a courageous journalist recently described how to manipulate the credit default swap market in this post from three years ago:
http://www.marketrap.com/article/view_article/91172/did-the-markit-group-a-black-box-company-partially-owned-by-goldman-sachs-and-jp-morgan-devastate-markets


Is there sufficient regulatory scrutiny to prevent CDS trading on inside information?

No. The SEC launched the first action alleging insider trading in 2009, but it was ultimately unsuccessful:
http://www.sec.gov/news/press/2009/2009-102.htm

The fact that insider trading is a serious problem was highlighted by this announcement from the UK’s Financial Services Authority in 2011:
http://www.bloomberg.com/news/2011-03-25/fsa-said-to-review-credit-default-swaps-in-market-abuse-probe.html

That leads us to perhaps the most saddening question of those posed above:

Has there been tacit cooperation among market participants and data vendors to preserve the status quo in the CDS mud pit?

Yes. Perhaps the most egregious form of cooperation is the effort to preserve the impression that there is active trading in a large number of reference names when in fact there is not.  For a review of trading volume reported by the DTCC, see the following links:

All Reference Names:
http://www.kamakuraco.com/Blog/tabid/231/EntryId/365/CDS-Trading-Volume-for-1-090-Reference-Names.aspx

U.S. Banks:
http://www.kamakuraco.com/Blog/tabid/231/EntryId/366/Credit-Default-Swaps-and-Deposit-Insurance.aspx

Sovereigns:
http://www.kamakuraco.com/Blog/tabid/231/EntryId/368/Sovereign-Credit-Default-Swap-Trading-Volume.aspx

Sub-Sovereigns and Municipals:
http://www.kamakuraco.com/Blog/tabid/231/EntryId/367/Municipal-Credit-Default-Swap-Trading-Volume.aspx

Breathless reporters or rating agencies claim “Dell’s CDS widen 42%” when, in fact, there were only 9.6 gross trades per day and 1.75 non-dealer trades per day in Dell during the week ended May 25, 2012, according to DTCC:
http://finance.yahoo.com/news/fitch-solutions-dells-cds-widen-120600373.html

Reporters need a story, and the CDS mud pit provides material.  Rating agencies need a product that is not a rating, and the CDS mud pit provides one.  CDS data vendors couldn’t sell CDS data if it were well known that (a) 81.68% of trades in the DTCC trade warehouse were trades between dealers or (b) more than 50% of the reference names for which data were reported by the vendor had NO trades in a given week, on average.

Creating a CDS Market Out of the Mud Pit

Existing beneficiaries of the CDS mud pit have no incentive to change things and lots of incentives not to change things.  These changes must be forced by laws and regulations.  The necessary changes should emulate the information and data flow of the market for common stocks and options.  These markets, while not yet perfect, are one million times more transparent and competitive than the CDS mud pit:

  • Distribute data through a large number of data vendors as the New York Stock Exchange does
  • Display bid levels and bid volumes in real time
  • Display offered levels and offered volumes in real time
  • Display traded prices and traded volumes in real time
  • Require disclosure of all entities with large open positions, both long and short, as is required in the market for common stock
  • Aggressively enforce insider trading rules
  • Force trading onto legitimate exchanges.  Industry resistance to this is long standing but that is irrelevant. The investors’ interest is of greater import.
  • Use the Department of Justice whenever necessary to establish competition in the market place

Until then, whenever one sees a credit default swap quotation, it should be regarded with an extremely high degree of suspicion.

Donald R. van Deventer
Kamakura Corporation
Honolulu, June 6, 2012

Copyright © 2012 by Donald R. van Deventer.  All rights reserved.

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