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 simple one: is the arena for credit default swap trading a marketplace or a mud pit?
Sadly, the answer is the latter. Without reforms, the CDS mud pit is likely to suffer the same fate as collateralized debt obligation: total irrelevance.
What do I mean by "mud pit"? I am in essence asking the following questions:
- Is there a transparent and open transmission of traded prices, bids and offers 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 answer to the question above is "no," and 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: Has there been tacit cooperation among market participants and data vendors to preserve the status quo in the CDS mud pit?
To explain all this, I'm going to focus on single-name credit default swaps, not the credit default swap index market in which JPMorgan has suffered its $2 billion of losses. The reason for this focus is 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.
Let's start with pricing information. In spite of changes in reporting by the Depository Trust and Clearing Corp. in recent years, the single-name CDS bids, offers, 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 that distributes CDS data time-stamps bids, offers and trades in its data service, it is the exception, not the rule, and this outfit has a small market share. The primary service offered by the largest CDS data vendor does not distinguish between bids, offers, and traded prices.
Moreover, this 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, offers, or traded prices) since the week ended July 16, 2010.
The DTCC has information about trade volume, but has made it available only on a weekly basis with a three-business day lag, starting with that same week in 2010. Through January of this year 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."