Decoding Derivatives – Q2 2021

DC transparency, really?

The credit derivatives determinations process has, for some time, been clouded in relative mystery. As credit default swap (CDS) strategies have grown more complex and gray-area issues have become more commonplace, advocacy in front of the Determinations Committee (DC) has also ramped up. In most instances, determination requests and other material and argumentation pieces submitted to the DC were made available via the DC website. Recently, however, the DC appears to have ceased its practice of publishing even plain vanilla determination requests in whole, in favor of simply summarizing the requests and/or views of market participants on specific issues. The ultimate goal may well be to limit the amount of (competing) submissions by market participants on the same issue or request. After all, market participants may be less incentivized to submit their own views on a specific issue if they do not see an argumentation piece they may disagree with. However, this approach does leave open the question as to whether the DC is providing full context to market participants. At a minimum, the DC does not seem to have gone as far as prohibiting requests advocating a specific outcome, but the DC is one step closer. Also, while the DC appears to be working to reduce the level of advocacy it receives, a lack of transparency may well lead to more market participants making submissions to ensure their views are taken into account. Ultimately, it will be difficult to police the behavior of market participants standing to make or lose big on their trades. On our end, we would favor increased transparency of market participants’ submissions, perhaps not on a live basis, but at a minimum once the DC has made a final determination on a specific request.

Kramer Levin’s leading voice on CDS

Consistent with our position as the thought leader in the CDS market, we have teamed up with LexisNexis to author its CDS content*. 

Corporate bond market embraces remote working

In 2020, many people moved to working outside of the office; in 2021, corporate bond investors can now gain exposure to corporate bonds without going into the bond market. Cboe has started offering bond index futures, allowing market participants to gain exposure to U.S. corporate bonds synthetically. The Cboe index futures, at least in essence, offer a competing product to index CDS. While the $8.8 trillion U.S. corporate bond market offers a sizable pie for competing products, the introduction of index futures adds a competitor to a previously monopolized space. Initial trading in the high yield index futures was around $200 million, with around $100 million in investment grade, and it remains to be seen how much open interest this product will attract.

LIBOR Decathlon: CDS hurtles toward transition

CDS clearing houses LCH and ICE transitioned toward post-LIBOR risk-free rates in Q2. Until the transition, LCH and ICE had been using federal funds and EONIA for valuation purposes for cleared CDS. Now, cleared CDS models adopt SOFR for valuation and margining purposes, with market participants’ accounts being adjusted for the impact of the transition. This $2.3 trillion product transition is yet another boon to the LIBOR transition.

Mapping CDS in the EU

A recent European Systemic Risk Board paper studies the relationship between cross-border holdings of credit derivatives and cross-border investment linkages in the European Union. The study shows that larger amounts of credit derivatives are bought and sold on residents of financial partner countries. It shows that when banking systems are net buyers, they purchase more net protection on countries to which they have larger portfolio debt exposures on average (which in turn reduces bilateral credit exposures). Conversely, when banking systems are net sellers, they tend to sell larger amounts of protection on countries where they have larger portfolio debt holdings (thereby increasing their exposures).

*_{This excerpt from Practical Guidance®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.}