Fitch finds CDS participants should act before times of stress

Credit default swaps (CDS), although an efficient risk management tool, should not be used solely in reaction to times of greatest stress when many corporates are illiquid, said a Fitch Ratings special report, Liquidity in the credit default swap market: too little too late? .

“Even for apparently liquid names, market volumes can quickly dry up,” said the June 7 report. For instance in six liquid names the report examined, Fitch observed that the market “often shut down completely” at times of stress.

According to the report, the lack of liquidity in the CDS market during times of stress may make it difficult to hedge exposures. “Until the CDS market matures, it is important that entities using the CDS market to hedge credit risk do not rely on a purely reactive approach, otherwise they run the risk of being shut out of the market at exactly the point when they need protection the most,” said the report.

According to Fitch, one of the more surprising results of the report was that debt outstanding was only weakly correlated to liquidity. “Instead… by far the most important factor to help understand liquidity was whether the entity concerned was a common reference name in the synthetic CDO market.”

Fitch examined twelve high-profile fallen angels - investment-grade companies downgraded to non-investment grade - to assess how liquidity changes during stressed periods. According to Fitch, the data can provide an insight into whether institutions can actually buy credit protection on an entity at the time it is most needed, and whether sellers of protection can find a market before a period of stress.

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