The OTC derivatives market had a rough two years in the press. It started off with simply blaming the entire crisis on the OTC market. That was fashionable for a while, but it turned out to be total nonsense. So the new face-saving gloss is to distinguish between causation and severity: you see, the OTC market didn’t cause the crisis, but it did made things worse. It seems this equally ridiculous claim isn’t enough for the press, given the latest hail storm of nonsense accusations. For after all, there is still plenty of ad revenue to be generated with rabble rousing, uninformed commentary on buzz words. So what’s the latest theory? It’s two fold. First, the CDS market is “opaque.” Second, speculation is rampant, rampant I say! And it’s adversely affecting asset prices outside the CDS market. Below I address the first prong of this theory, and show that not only is the CDS market relatively transparent, but that it generates more useful information than the bond market.
Is The CDS Market Opaque?
When people claim the CDS market is opaque, they are usually alluding to a perceived absence of price information. Specifically, they claim the market is opaque because it’s rooted in “private contracts,” the terms of which are never revealed to the public. As Ricky Gervais likes to tell his co-host Karl Pilkington, “that is absolute bollocks.” If you’re interested in how the CDS market is doing on a given day, I recommend a little-known publication: it’s called the Financial Times. Specifically, check out FT’s Alphaville, because they have a daily round-up on spread movements in the CDS market. But if you’re really a fan of CDS spreads and a summary won’t do, you can check out Markit’s last quote of the day report, where you can find quotes for the most commonly traded names in the CDS market.
In fairness to critics, there is certainly less publicly available price information from the CDS market than that available from the world’s largest stock exchanges. But why are people so preoccupied with transparency in the CDS market? The level of publicly available information from the CDS market is on par with that from the corporate bond market, yet no one has a problem with a lack of transparency there. Moreover, the interest rate swap market is literally an order of magnitude larger than the CDS market, yet no one seems concerned with transparency there either. This suggests that those pushing for transparency in the CDS market are either intentionally selective or unintentionally ignorant.
A Closer Look at Bonds vs. CDS
Bonds are in essence loans with some distinguishing characteristics that aren’t relevant to our discussion. Typically, the issuer of a bond needs capital to run its business and so it works with an underwriter who, among other things, lines up buyers interested in purchasing the issuer’s debt. These buyers, or bondholders, purchase pieces of paper that represent the issuer’s promise to pay a fixed amount of money at some future date, known as the maturity date. And so by purchasing bonds, the bondholders lend money to the issuer. These bondholders will want something in return for their generosity, which is known as interest. The more confident the bondholders are in the ability of the issuer to pay down the bond, the less they will demand in interest. As a result, when people want to get a sense of the creditworthiness of an issuer, they look at the difference between the effective interest rate on that issuer’s debt, known as the yield, and the risk free rate. The risk free rate is supposed to be the pure opportunity cost of money, with no risk of default attached. In reality, people often use the yield on a strong, government backed obligation, like U.S. Treasuries, as a proxy. So if XYZ corp issues a bond maturing in March of 2015, you could look to the difference between the yield on that bond and the yield on U.S. Treasuries maturing around the same time.
The problem with simply looking at the difference, or spread, between an issuer’s bonds and the risk free rate is that issuers tend to have a lot of different bonds outstanding, each of which could have different prices, and therefore different yields. This means that it’s difficult to get an overall, market-based sense of the creditworthiness of an individual issuer looking only to the bond market. This is not the case in the CDS market.
Generally, a credit default swap is an agreement between two parties that names an issuer of bonds, say XYZ corp. One party, the protection buyer, pays a quarterly fee to the other party, the protection seller. In exchange for these payments, the protection seller agrees to pay the protection buyer an amount based on the value of XYZ corp’s bonds if and when XYZ corp defaults on its bonds. If XYZ corp never defaults, the contract simply terminates after a fixed period of time. If XYZ corp does default, the parties settle the contract. The simplest method of settlement is physical delivery, where the protection buyer delivers XYZ corp bonds to the protection seller, and the protection seller pays the full face value of the bonds. So, for example, if XYZ corp defaults and has a series of bonds trading at 30 cents on the dollar, the protection buyer could deliver these to settle the contract, receive 100 cents on the dollar, and net 70 cents. Generally, the protection buyer is allowed to deliver a wide range of XYZ corp bonds to settle the contract. This means that the protection seller, the party paying full face value for the bonds upon default, will charge a quarterly fee that reflects XYZ’s overall credit quality, and thereby average-out any idiosyncratic properties of any particular series of XYZ corp bonds. Therefore, by looking to the fees that protection sellers demand in the CDS market, we can get an overall, market-based sense of the creditworthiness of a particular issuer.
Without the CDS market, credit quality would be and was a product of subjective models, since we’d have to look at the spreads on the whole spectrum of debt that a given issuer has outstanding, and then use subjective – but not necessarily arbitrary – methods of averaging them. 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. Now ask yourself: what kind of issuers does this level of transparency threaten?
Originally published at Derivative Dribble and reproduced here with the author’s permission.