As with a CDS, buyers of CCDS protection receive par value minus the recovery rate if the reference entity defaults. However, unlike a CDS, the notional of a CCDS is variable and contingent on the mark-to-market value of another derivatives contract – making it a good hedge against counterparty risk.
Counterparty risk management has long been the product’s primary role, with bank desks typically trading the product with other dealers or sophisticated investors, such as hedge funds. But in the past six months there has been heightened interest in using the product to take advantage of elevated correlations between asset classes, according to market participants.
David Nardiello, a primary CCDS correlation trader at Citi in New York, said the product has received attention from a more diverse group of investors over the past six months. “We have seen interest in the product driven in part by the increasing correlations between risk assets. This phenomenon has caused investors to rethink traditional diversification principles. In this context, CCDS is being viewed as an option hedge against structural portfolio weaknesses.”
The product's cheerleaders are eager to goose up interest in trading CCDS among speculative players to help create a more liquid market in counterparty exposures. In the past, CCDS trades referencing automakers and oil prices, for example, have managed to catch the attention of a wider range of investors.
More recently, Citi analysts have suggested buying CCDSs on series 12 of the Markit North America CDX Investment Grade index, linked to a pay-fixed interest rate swap. Effectively, this comprises a bet that investment-grade corporate spreads will widen while interest rates also increase. While this could be achieved using plain vanilla CDSs and interest rate swaps, the use of CCDSs lowers the cost of taking this view, said Nardiello. “If you are concerned about the simultaneous threat of credit spreads widening and interest rates widening, this is definitely the product to express it with.”
In fact, if the proposed trade was not delta-hedged, investors would benefit from an increase in rates even if the CDX tightened, according to Citi.
Since the strategy was touted, the bank has received around 20 enquiries from investors that would not normally trade CCDSs, Nardiello said.
Talks by dealers aimed at bolstering the CCDS market by launching a standardised swap-deliverable version of the contract fizzled out last year amid market disruption. Swap-deliverable CCDSs allow protection buyers to receive the actual reference derivatives trade in the event of default, as opposed to a bond of the reference entity. Such contracts are more desirable for counterparty risk managers, as they eliminate the need to find an eligible reference obligation to hedge counterparty exposures using a CCDS.