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« Changes to our Calculations of PnL on Short Spread Trades | Main | Was 2011 a Dud or a Springboard for Gold? »

Why We Need an Exchange Based CDS Market

It is our belief that the global financial markets would function in a much more efficient and stable manner if Credit Default Swaps were traded on an exchanges and made available to smaller professional traders and even retail investors. We think that this would increase transparency and reduce contagion and counterparty risks in the market.

We will begin with a brief introduction for those less familiar with the instruments discussed in this article. A Credit Default Swap (CDS) is a swap designed to transfer the credit exposure of fixed income products between parties. CDS are similar to traditional insurance policies as it obliges the seller of the CDS to compensate the buyer in the event of a loan default. The difference lies in the fact that anyone can purchase a CDS, even if the buyer has no direct insurable interest in the loan. The buyer of the CDS makes payments to the seller and in exchange if the loan defaults the buyer receives a payout.

CDS are increasingly on the radar for all market participants. Whereas just a few years ago they were only followed by larger institutional players, now even many retail investors and traders will take a keen interest in developments in CDS markets. Although smaller traders or investors may monitor what happens in CDS markets and often have a view on where various CDS prices are going, they are as yet unable to directly speculate or hedge their investments using CDS. We therefore think that there is a market that could be potentially exploited in offering trading vehicles that track CDS to participants who are otherwise unable to trade CDS directly.

The barriers that prevent smaller market players gaining exposure to the CDS market are fairly clear. CDS are usually based on large notional amounts, usually $10M, therefore smaller players simply cannot afford to enter these swaps on either side. In addition to this, the concept of a swap is less well known to retail investors than other forms of derivatives such as futures and options, this is a symptom of retail investors not often being able to afford to enter the swaps market. However a growing number of investors understand what changes in CDS mean and the implications that developments in the CDS markets has on the wider global market place and economy.

Despite the growing understanding and publicity of CDS, market products have yet to be developed for smaller market participants to use CDS to hedge a portfolio or speculate on an outcome. If we look to other markets that were previously unavailable to retail investors we can see that financial innovation has developed products that allow retail investors to take positions in these markets.

The explosion in new ETFs/ETNs is one example of how financial innovation has been able to open up new markets to retail investors and traders. Trading emerging markets, commodities and specific market sectors can now easily be done by even the smaller retail investor. Another example is the increase in the use of CFDs which have opened up money market futures, currencies and even speculating on key data such as monthly NFP numbers to anyone with access to around $1,000.00. We believe that if there are futures for obscure things like rainfall, it makes sense for CDS to also trade on an exchange, preferably as an exchange traded futures contract based on the price of the CDS. By initiating this exchange, it means that retail investors are able to have access to the CDS market.

It is said that greater transparency leads to greater efficiency and greater liquidity; if one accepts this assertion then naturally one should accept the need for CDS to become exchange traded. Currently the CDS market is sometimes a murky one, and by creating an exchange for CDS, market regulations are put in place that create much more transparency. This exchange will further bring additional stability, reduce distortions in the market and bring greater liquidity as fresh money enters the market to speculate or hedge risk via CDS.

Contrary to what many believe, introducing a CDS market would actually lead to a reduction in contagion risk. Financial contagion is defined as a shock to one country's asset market that causes changes in asset prices in another country's financial market. An example of financial contagion is the "Asian Contagion" which occurred in 1997 and started in Thailand and spread throughout South East Asia. If a retail CDS market existed at this time, although it may not have stopped the spread, it would have reduced the effects. It would have done this by giving investors a way to effectively hedge their investments in Thailand. Therefore panic would have been reduced and although Thailand would have crashed either way, it would have provided a softer landing for its Asian neighbours. We see a similar situation in Europe today. How much of the panic selling in quality US stocks during the numerous episodes of panic over Greek debt could have been avoided by giving investors the ability to directly hedge that risk by “Greek CDS futures”? Or by Portuguese, Spanish or Italian CDS futures? It may not have completely stopped the selling, but it would have certainly contributed to a reduction in the incentives to sell US stocks.

Furthermore creating an exchange for the CDS market it will greatly reduce counterparty risk. Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. In the current market two parties enter into a contract, this means that each rely on each other to make good on the contract in the future. This is fine until a financial institution takes on too much risk and the market goes against them, which leads to them not being able to fulfill the CDS contracts, which then leads to bankruptcy. The company on the receiving end is not able to recover its funds and this could cause them to also enter into bankruptcy if the contract size was large enough, which starts a chain effect. This contagion would not happen in a regulated CDS exchange, as the exchange takes on the counter party risk. It would also mean that companies would have to place margins on the contracts and the exchange would know the company’s exposure to capital ratio.

In conclusion, by creating an exchange for the CDS market we could achieve increased liquidity, greater transparency, greatly reduced counter party risk, reduced contagion risk and the retail investor will have a chance to speculate and/or hedge.

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