The market participants are very surprised by the negative perception of credit derivatives, as expressed by politicians, regulators, the media, internet blogs, and others. They find the extent of blame attributed to credit derivatives, for either causing the market meltdown or otherwise negatively affecting market dynamics, mostly misplaced, the latest Global Credit Derivatives Survey by Fitch Market Research show.
“Also noted were misconceptions regarding the impact of CDS price action on sovereign cash market spreads, as well as comments regarding George Soros’ characterization of naked CDS positions as toxic.”
“The rapid growth of the credit derivatives (CDx) market prior to 2007, its absolute size as measured by gross notional amounts, and its perceived role in the current global financial crisis have led to intense scrutiny and much debate among market participants, regulators and policy makers about the need for significant change in market practices and on ways to strengthen regulatory oversight. This year’s survey was undertaken in the midst of significant and transformational changes taking place within the CDx market,” Fitch Market Research writes.
This year’s survey, which is the seventh conducted by Fitch, includes 29 banks from 10 countries.
The survey was undertaken in the midst of significant and transformational changes taking place within the CDx
market and therefore focuses on some of these key issues in addition to traditional themes such as:
* Surprises and challenges for the CDx market from the perspective of market participants.
* The current state of the market, including key growth trends.
* A brief sector review of banks and insurance companies.
Market Shrinks By 64%
The overall market for credit derivatives (CDx) shrunk to $1,8 trillion in 2009 from $5,1 trillion in 2008, the survey show.
The 29 banks surveyed by Fitch had a notional sold volume of CDx contracts totaling $10.6 trillion at year-end 2009, and a notional bought volume of $10.9 trillion at year end 2009.
(The notional amount refers to the par amount of credit protection bought and sold.)
“The decline in both sold and bought (24% for sold, 22% for bought) notional amounts as compared to 2008 reflects a combination of factors,” Fitch writes and points at the following:
1. Industry initiatives to ‘compress’ and ‘tear up’ CDx transactions that eliminate redundant offsetting contracts (while compressions replace offsetting redundant contracts with a smaller number of replacement contracts, tear-ups eliminate them).
2. A reduction in overall trading activity which is partially attributable to risk aversion, deleveraging within the broader financial sector, and a cautious approach to the CDx market in the face of heightened regulatory uncertainty.
3. Increased use of collateral and netting agreements.
4. The fact that Fitch’s survey sample for the two years differed somewhat.
The survey also confirms that trading for profit is still the main motivator in the derivative market – not the insurance that the instruments originally is designed for.
The Survey Highlights
* Regulation in general was one of the most often cited challenges, with commentary ranging from the prospects of dealing with regulatory perceptions of the market to being over-regulated on several fronts.
* Ninety-six percent of market participants surveyed agree that central clearing is called for, and most believe it would reduce systemic risk. However, there was less of a consensus among survey respondents as to the desirability of having multiple clearing houses or the exchange trading of CDx.
* Some survey respondents were surprised at the extent to which the market meltdown or negative dynamics were attributed by market observers to the use of CDx.
* Hedging, basis trades, the traded indices, and sovereign strategies were all noted by market participants as those that grew over the last year. On the downside, CDOs and more leveraged structures were mentioned as laggards.
* At year-end 2009, single-name CDS and indices continued to dominate the market; while both products make up more than 90% of the total CDx market, it is notable that on a relative basis the use of indices has fallen for the first time.
* The development of the sovereign CDS market in terms of volumes and general relevance was noted by respondents, with 89% expecting sovereign CDS use to grow in the future.
* The top 10 counterparties comprised 78% of the total exposure in terms of the number of times cited, up from the 67% reported last year, reflecting the dominant role of banks and dealers as counterparties and the consolidation of counterparties post-crisis.
* While the banks surveyed by Fitch saw a decline in both sold and bought positions, they continued to have relatively balanced portfolios in the aggregate. Although some banks shifted from being net protection sellers to net protection buyers, there were no significant movements in the other direction.
* Sixty percent of survey respondents acknowledged the growing importance of the risk management function within banks and the role of the chief risk officer, compared with 40% in the previous year.
* Given the concentrated nature of the CDx market, the continued importance of counterparty risk management was highlighted by 53% of survey respondents. The most recent findings matched the results seen two years earlier.
Biggest Surprise: Public’s Perceptions
There has been no shortage of commentary regarding CDx from market observers such as politicians, regulators, the media, Internet blogs, and others.
Among the bigger surprises noted by several respondents was the extent of blame attributed to CDx for either causing the market meltdown or otherwise negatively affecting market dynamics, and a seeming lack of understanding of the role/mechanics of CDS in general.
“One respondent commented on the apparent lack of distinction between structured finance products (e.g. RMBS securities) and CDS. Also noted were misconceptions regarding the impact of CDS price action on sovereign cash market spreads, as well as comments regarding George Soros’ characterization of naked CDS positions as “toxic,” Fitch says.
Receiving several mentions in this category were surprises related to the perceptions of regulators.
Other comments were wide-ranging, from those related to Basel II reforms, to calls for a central clearinghouse/exchange.
Of all surprises related to the past year’s events, those related to sovereigns were among the most prominent.
In particular, the growth of the sovereign CDS market in terms of volumes and general relevance was noted by a number of respondents.
Other responses pointed to the sovereign crisis in a general sense, but without a specific tie-in to CDS.
Beyond sovereign trading action, comments related to spread action in general garnered the most number of responses as being surprising, ranging from volatility that was greater than expected, to shifts in the basis between CDS and cash
instruments, to the spread rally that followed the depths of the credit crisis.
Fitch have also asked market participants specifically what they believe is the impact of CDS has been on the broader marketplace.
While some survey respondents noted that various market observers have blamed CDS for exacerbating or significantly contributing to the recent credit crisis, this is the view of the market participants themselves.
The King of Derivatives
The survey also disclose who’s the biggest player in this market.
The title as King of Derivatives 2010 belongs – indisputable – to JP Morgan Chase & Co.
For more interesting reading, here’s the full report “Global Credit Derivatives Survey” from Fitch.
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