Trading volume in the bond and credit default swap markets, particularly the sovereign credit default swap market, is one of the key drivers of profit for major dealers like Bank of America (BAC), Barclays Bank PLC, BNP Paribas (BNPZY), Citigroup (C), Credit Suisse (CS), Deutsche Bank (DB), Goldman Sachs (GS), HSBC Holdings (HSBC), JPMorgan Chase (JPM), Morgan Stanley (MS), The Royal Bank of Scotland Group PLC (RBS), and UBS AG (UBS). This update adds some details to the nice Wall Street Journal study “Where did Europe’s Sovereign CDS Trading Go?” which analyzes the European Commission’s ban on the short sales of sovereign credit default swaps.
That ban,announced on July 5, 2012, is explained in thistext from the European Commission. The regulation became effective on November 1, 2012. The full text of the regulation is available from the European Commission website.
Conclusions: If there is sector of the credit default swap market which has shown decent trading activity over the last 233 weeks, it is the sovereign sector, primarily the top 6 reference names. Trading volume, however, has declined in a statistically significant way for 10 of the 12 most heavily traded Member States of the European Union. We explain how these conclusions were reached in what follows.
The Analysis of Sovereign Credit Default Swap Trading Volume
In this note, we analyze the trading volume for all sovereign reference names as reported by the Depository Trust & Clearing Corporation. We also analyze the impact on volume of the European Commission’s ban on short sales of sovereign debt. The European Commission regulation bans the short sale of credit default swaps on issuers that meet the following definition in the act (Chapter 1, Article 2, section 1):
“(d) ‘sovereign issuer’ means any of the following that issues debt instruments:
- The Union;
- A Member State, including a government department, an agency, or a special purpose vehicle of the Member State;
- In the case of a federal Member State, a member of the federation;
- A special purpose vehicle for several Member States;
- An international financial institution established by two or more Member States which has the purpose of mobilizing funding and provide financial assistance to the benefit of its members that are experiencing or threatened by severe financing problems; or
- The European Investment Bank”
The Member States of the European Union are listed here along with their year of entry into the Union:
- Austria (1995)
- Belgium (1952)
- Bulgaria (2007)
- Croatia (2013)
- Cyprus (2004)
- Czech Republic (2004)
- Denmark (1973)
- Estonia (2004)
- Finland (1995)
- France (1952)
- Germany (1952)
- Greece (1981)
- Hungary (2004)
- Ireland (1973)
- Italy (1952)
- Latvia (2004)
- Lithuania (2004)
- Luxembourg (1952)
- Malta (2004)
- Netherlands (1952)
- Poland (2004)
- Portugal (1986)
- Romania (2007)
- Slovakia (2004)
- Slovenia (2004)
- Spain (1986)
- Sweden (1995)
- United Kingdom (1973)
On January 8, 2015 Kamakura Corporation reviewed trading volume in credit default swaps for 1,239 reference names reported by the Depository Trust & Clearing Corporation and found that only 4 reference names in the world had averaged more than 10 or non-dealer trades per day in the 233 weeks ended on December 26, 2014. In this note, we look at weekly credit default swap trading volume for sovereigns among those 1,239 reference names. This report is an update of the Kamakura sovereign credit default swap trading volume analysis of July 14, 2014 . We continue to find that a small set of sovereigns leads trading volume in single name credit default swaps: Spain, Italy, Brazil, and France. Beyond those names, trading volume drops off rapidly.
The weekly trade information we analyze is from the Section IV reports from DTCC. The data is described this way in the DTCC document “Explanation of Trade Information Warehouse Data” (May, 2011):
“Section IV (Weekly Transaction Activity) provides weekly activity where market participants were engaging in market risk transfer activity. The transaction types include new trades between two parties, a termination of an existing transaction, or the assignment of an existing transaction to a third party. Section IV excludes transactions which did not result in a change in the market risk position of the market participants, and are not market activity. For example, central counterparty clearing, and portfolio compression both terminate existing transactions and re-book new transactions or amend existing transactions. These transactions still maintain the same risk profile and consequently are not included as ‘market risk transfer activity.’”
As discussed in the January 8, 2015 report, our emphasis is not on gross trading volume. As of January 10, 2014, dealer-dealer volume is 72.48%% in the single name credit default swap market and it would be nearly costless for dealers to inflate gross trading volume by trading among themselves. Instead, we focus on “end user” trading where at least one of the parties to a trade is not a dealer. Accordingly, we make the following adjustments to the weekly number of trades reported by DTCC for each sovereign reference name:
- We divide each weekly number of trades by 5 to convert weekly trading volume to an average daily volume for that week.
- From that gross daily average number of trades, we classify 72.48% of trades as “dealer-dealer” trades, using the average “dealer-dealer” share of trades in the DTCC trade warehouse on January 10, 2014.
- The remaining 27.52% is classified as daily average “non-dealer” volume, the focus of the reporting below.
Important note: the trading averages for each reference name are reported only for those weeks in which there were trades. In other words, the averages are conditional on trades taking place.
Daily Non-Dealer Trading Volume for Sovereign Reference Names
Of the 1,239 reference names for which DTCC reported credit default swap trades in the 233 week period, only 60 were sovereigns. The only new sovereign reference name traded in the last six months was the Kingdom of Morocco. 26 of the 28 Member States of the European Union have had some credit default swap trading during the 233 weeks ended December 26, 2014. Those members of the European Union are highlighted in bold:
No credit default swap trades were reported in the 233 weeks ending December 26, 2014 for the other 124 sovereigns which have default probabilities in Kamakura Risk Information Services sovereign default service.
Analysis of Daily Average Non-Dealer Trades Per Day
We first analyze the 233 week averages for the 60 sovereigns for which CDS trading volume was greater than zero during the 233 weeks ending December 26, 2014. The daily average non-dealer trading volume, calculated as described above, was distributed as follows:
The conclusions that can be drawn from this table are summarized here:
- 75% of the 60 sovereigns averaged less than 4.50 non-dealer CDS trade per day.
- 95% of the 60 sovereigns averaged less than 12.39 non-dealer CDS trades per day.
- 99% of the 60 sovereigns averaged less than 16.87 non-dealer CDS trades per day.
- The average 233 week daily average number of non-dealer trades per day for the 60 sovereigns was 3.18 trades per day
- The median 233 week daily average number of non-dealer trades per day was 1.29 trades per day
In spite of the European Commission ban on short sales, we conclude that trading volume for the most active sovereigns is higher than it is for the most active corporations, which is only logical given that such sovereigns issue more debt than the most active corporations. The correlation between trading volume and debt outstanding is weak, however, with the United States well down on the ranking of trade volume in spite of the high volume of U.S. debt outstanding.
Analyzing Trading Volume in Aggregate
We now analyze all 233 weeks of data, not just the average over that period, for all 60 sovereigns for which DTCC reported non-zero trade volume. There were 12,318 actual observations (compared to a maximum potential number of observations equal to 13,980 = 60 x 233) observations on CDS trading volume for these 60 sovereigns, and there were no trades for 1,662 observations, 11.9% of the total potential observations. The distribution of non-dealer trades per day over the 12,318 non-zero observations is summarized in the following chart:
One can draw the following conclusions over 12,318 non-zero weekly observations:
- 75% of the observations showed 4.13 non-dealer trade per day or less
- 95% of the observations showed 14.48 non-dealer trades per day or less
- 99% of the observations showed 28.13 non-dealer trades per day or less
- There were only 13 observations that showed more than 50 non-dealer trades per day or more
- The highest volume week was March 14, 2014, during which the Russian Federation traded 92.96 non-dealer trades per day.
While the sovereign CDS market shows more non-dealer CDS daily average volume than the corporate market, trading is concentrated in a relatively few names. 124 sovereigns had no CDS trades at all over the 233 week period studied.
Detailed Information on CDS Trading Volume by Individual Reference Name
The weekly, daily, and daily non-dealer trading volume for the top 25 sovereign names is given here:
The number of contracts traded for the volume leader, Brazil, is shown in this graph:
The notional principal of these contracts traded on Brazil is shown in this graph of the 233 weeks of trading ended December 26, 2014:
Analysis of the Impact of the European Commission Short Sale Ban
Unlike the Wall Street Journal analysis cited above, our focus is solely on single name credit default swap trading in sovereign reference names. In analyzing whether or not the European Commission ban on short sales of sovereign debt has reduced credit default swap trading in European Union Member States, the task is complicated by the randomness in trading volume both before and after the ban took effect November 1, 2012. Accordingly, we perform the normal tests of statistical significance in order to determine whether a change in the mean level of non-dealer daily average contracts traded before and after the ban is statistically significant or not (i.e. the change could be due simply to the “noise” in trading volume over time). The results of the exercise are reported in this table:
We reach the following conclusions:
- Trading volume, as measured by daily average non-dealer credit default swaps traded, declined for 17 of the 26 European Union Member States on which there was credit default swap trading.
- This decline in trading volume was statistically significant at the 95% confidence level for 10 of the 17 Member States showing a trading decrease
- 9 of the 26 member states actually showed a trading volume increase, and another 7 member firms showed a trading decrease that was not statistically significant at the 95% confidence level.
- 10 of the 12 member states with the heaviest overall credit default swap trading volume showed a statistically significant decrease in trading volume.
The graph below shows the gross weekly number of trades by all counterparties in the Kingdom of Spain for the 233 weeks ended December 26, 2014. The decrease in volume after November 1, 2012 is quite striking.
The next graph shows the total amount of notional principal of credit default swap trading in the Kingdom of Spain over the same 233 week period.
Again, the decrease in trading volume after the November 1, 2012 ban took effect is plain to see even without the statistical backup, although the increase in volume in mid-2014 is sizable.
If there is sector of the credit default swap market which has shown decent trading activity over the last 233 weeks, it is the sovereign sector, primarily the top 6 reference names. Trading volume, however, has declined in a statistically significant way for 10 of the 12 most heavily traded Member States of the European Union. Only time will tell if the trading volume in the sovereign sector will regain its vitality or languish in the same “zombie state” as most other sectors of the single name credit default swap market.
Donald R. van Deventer
Honolulu, January 9, 2014
Copyright ©2015 Donald van Deventer