Challenged single-name CDS market takes optimistic turn

Single-name credit-default swap (CDS) volumes may have jumped to a nine-year high last quarter, but the market remains a shadow of its former self and continues to show signs of illiquidity.

Even as participants reject recent regulatory attention on the market’s supposed opacity and lack of central clearing, they point to ongoing concerns about limited dealer activity and regulatory constraints that could hamper a sustained revival.

Still, the good news for liquidity is hard to miss. With average daily volumes (ADV) exceeding $20 billion, trading in the first quarter rose to its highest level since the second quarter of 2014, according to Depository Trust & Clearing Corporation figures for the top 1,000 single names.

Quarterly volumes had already been rising from their 2019 and 2020 lows, but the first quarter’s activity nearly doubled volumes from the prior three-month period. The gains were widely distributed, with the average name on the DTCC’s list seeing its ADV jump from $15.4 million to $29.1 million.

The gains meant that contracts on more reference entities traded at least $10 million ADV than they have since late 2015. CDS trading on 40 reference entities exceeded $100 million notional a day, the most since the second quarter of 2014.

But the good news papers over the market’s hard-to-ignore cracks.

Even with the first quarter’s record volumes, the DTCC’s list continued to feature fewer names than in the past. While the average volume on each name has risen, the universe of tradeable names has shrunk.

So too has the number of dealers servicing the product. The average reference entity featured on the DTCC’s fourth-quarter list had 4.7 dealers trading the name, a slight drop from the previous quarter and a continued decline in competition.

The proportion of featured reference entities with at least five and at least 10 dealers trading the names has remained relatively steady in recent years. Last quarter, half of the names had fewer than five interested dealers, while 92% had fewer than 10.

For a market that trades on a request-for-quote basis, a smaller dealer base makes the market more dependent on a single dealer’s activity and priorities, and gives banks less opportunity to hedge their own exposure.

“There is no real depth. It is difficult to transfer a large size, and the market-makers are very defensive and quite scared about offering liquidity. There is clearly lack of motivation to develop this market. I don’t really understand why,” laments a buy-side trader of single-name CDSs.

In late March, Andrea Enria, chair of the European Central Bank’s supervisory board, called the single-name market “very opaque, very shallow and very illiquid”. It came after a small trade in Deutsche Bank’s CDS reportedly caused the spread to blow out, causing a knock-on effect on its share price.

“With a few millions, you can move the CDS spreads of trillion-euro-asset banks and contaminate stock prices and possibly also deposit outflows. So that is something that concerned me a lot,” said Enria in a question-and-answer session on March 28.

Enria’s comments elicited a defence from the derivatives industry body, the International Swaps and Derivatives Association, which pointed to post-financial crisis measures forcing the market to report trades to regulators and to publicly available repositories. Isda also noted the level of clearing coverage for single names.

Instead of focusing on clearing and transparency, participants argue the market’s decline has been much of the regulators’ own making, particularly the change in capital requirements for structured products such as collateralised debt obligations (CDOs).

“The story behind single-name liquidity is more the story of the consequences of killing the bespoke market for synthetic CDO products. This had huge repercussions on liquidity, hedging, the organisation of desks within banks, and so on. To recover, the CDS market needs to find investors willing to be long. The way it was done previously was through bespoke baskets,” says another buy-side CDS trader.

In synthetic products, banks wrap together single-name CDSs and sell slices of the resulting package to investors according to risk. The process boosts single-name trading and creates an exposure for the bank to hedge, further supporting liquidity.

The synthetic market still sees trading, but post-crisis capital requirements have helped dampen activity by making it unattractive for banks to hold tranches of synthetics on their books as they once would.

Traders say activity depends on whether the reference entity features in an index, since traders will look to arbitrage dislocations between an index and its constituents, known as skew. Trading the basis between CDSs and corresponding bonds also helps drive trading.

Given the changes weighing on single-name CDS trading in the past decade, the question now facing the market is whether the shift from a persistent low-rate environment that made it easier for challenged companies to take on debt – and likely helped jumpstart trading visible in last quarter’s gains – can prove to be a sustainable boost for the product.