Credit Default Swaps: Market or Mud Pit?
If manipulation of the interest rate benchmark inadvertently benefited borrowers, someone else had to pay the price.
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."
Fortunately, since January, this phrase has been removed.
What about competition? Using the Justice Department's standard measures of market concentration and volume data from the Office of the Comptroller of the Currency, I have found that the market for credit default swaps has been highly concentrated since its inception. But don't take my word for it. The European Commission announced last year that it was launching two antitrust investigations of the CDS market:
Regulation has failed to prevent manipulation of this highly concentrated market, as the writer Mark Mitchell documented three years ago. Trading on inside information has been a problem, as the U.K. Financial Services Authority highlighted last year. The SEC launched an action alleging insider trading in 2009, but it was ultimately unsuccessful:
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. I know this having reviewed trading volume reported by the DTCC for all CDS reference names, including U.S. banks, sovereign issuers, and regional and local governments.
Breathless reporters or rating agencies claim "Dell's CDS widen 42%" when, in fact, there were only 9.6 trades of any kind per day and 1.75 non-dealer trades in Dell during the week ended May 25, according to the DTCC.
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.
Vendors couldn't sell CDS data if it were well known that 82% of trades in the DTCC trade warehouse were between dealers. If it's the same 10 people passing the potato back and forth, where's the market?
Nor could vendors sell CDS data if it were well known that more than 50% of the reference names for which data were reported had no trades in a given week, on average.
Existing beneficiaries of the CDS mud pit have no incentive to change things and lots of incentives not to. The necessary changes should emulate the information and data flow of the markets for common stocks and options. These markets, while imperfect, are one million times more transparent and competitive than the CDS mud pit.
These changes must be forced by laws and regulations:
- Distribute data through a large number of data vendors as the New York Stock Exchange does
- Display bid, offered and traded levels and 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 longstanding but irrelevant. The investors' interest is of greater import.
- Use the Department of Justice whenever necessary to establish competition in the market.
Until these changes are made, whenever one sees a credit default swap quotation, it should be regarded with an extremely high degree of suspicion. If even JPMorgan, which pioneered this product, can be trapped in the mud pit, this market will die without reform.
Donald R. van Deventer is the founder, chairman and CEO of Kamakura Corp., a risk management firm in Honolulu. He is a former treasurer of First Interstate Bancorp in Los Angeles and a former vice president of risk management at Security Pacific National Bank.