Previous models have assumed that all assets become less liquid at times of financial turmoil. Fitch maintains that this is not necessarily the case with markets providing protection on the underlying assets, such as the CDS market.
The report's author, London-based credit analyst Thomas Aubrey, notes that over the last three years, B, BB and BBB-rated assets have consistently been the most liquid, followed by A, AA and AAA-rated assets, while C-rated were by far the most illiquid. This refutes the assumption that liquidity risk and credit risk cannot be separated.
The CDS market has become progressively more liquid over the last three years, bar a minor spike of illiquidity after August 2007. According to Fitch's liquidity scores, derived from its own model (the lower the score, the more liquid the asset), liquidity stood between 10.75 and 11 in the first half of 2006, improving to between 9.5 and 9.75 in September of this year. In fact, the liquidity in the CDS market has fared particularly well over the last six months, while liquidity in other markets has dried up.
However, while the market has generally become more liquid, the number of less liquid CDSs grows during the kind of stress periods seen in 2008. At these times, there is also a run on already liquid CDSs - in other words, the distribution of liquidity becomes more unequal.
Fitch concludes that credit events play a vital role in boosting the liquidity of a CDS, as investors who hold outstanding debt from the company become increasingly concerned that their bonds may default. For example, CDSs referencing Wachovia and Merrill Lynch had the best liquidity scores of all assets in September 2008, standing at 6.36 and 6.13 respectively. At the time, Merrill Lynch was negotiating a takeover by Bank of America, while Wachovia was being bought up by JP Morgan Chase.