Banks turn to CDS after electronic platforms flop
By Danielle Robinson
NEW YORK, Feb 24 (IFR) - Wall Street banks, having failed to make any money out of electronic bond-trading platforms, are now focusing on ways to benefit from new regulations enforcing the central clearing of credit default swaps.
A Greenwich Associates survey released last week revealed that only 1% of investment-grade corporate bond investors used single-dealer platforms, such as Goldman Sachs's GSessions, last year.
Nevertheless, banks such as Citigroup and Barclays are still keen to discover ways to offset derivatives and trading profits lost due to stricter regulations, and are hoping there will be a jump in single-name CDS use once the SEC rules later this year that they need to be centrally cleared.
"We think that moving CDS credit clearing to a central counterparty gives rise to a more specific use of CDS as a rating enhancement tool," said Peter Aherne, head of North American capital markets, syndicate and new products at Citigroup.
The use of single-name CDS has dropped by about a third since the crisis, according to Morgan Stanley, to around US$1trn outstanding in net notional terms. Banks and other users have found it less useful to hedge against credit risk in an environment of record low default rates.
But Morgan Stanley's Sivan Mahadevan, head of US credit strategy, believes CDS use will actually increase because of the Volcker Rule.
"Thanks to the Volcker Rule, market-making and general risk-mitigating activities in banks may motivate additional use of CDS," he said.
Barclays has become the first committed market-maker on MarketAxess's central limit order book electronic trading platform for single-name CDS.
"We are hopeful that these market structure changes lead to increased liquidity in the product," said Bob Douglass, head of credit electronic trading at Barclays.
Citigroup, meanwhile, has developed a bond product with eBond Advisors that aims to capitalize on the significant decline in counterparty risk once single-name CDS is centrally cleared.
The product involves an issuer putting language into the documents of a new bond issue that will allow those securities to become enhanceable by attaching CDS protection after launch. The end result is a single-CUSIP instrument that has the potential for an improved rating.
"The real value created by the eBond enhancement is the creation of a 'single' instrument for trading, rating, financing and accounting," said Richard MacWilliams, managing partner at eBond Advisors.
The eBonds can be enhanced as much or as little as the investor wants, can be traded as a single entity, or can be split into the two separate pieces. On a Triple B instrument, for example, 50% enhancement would imply a Single A rating, 80% Double A and 100% Triple A.
Among the potential users are bank treasury departments, currently swimming in excess liquidity and investing mostly in Treasuries and MBS.
Banks have been increasingly turning up in high-quality bond issues at the short end of the curve to boost investment returns in a low interest rate environment.
The eBond tool could conceivably enable them to purchase lower-rated bonds and enhance them up to the point where they are only exposed to rate risk, but still provide a higher yield than a government security.
The biggest potential users are investors who do not dabble in CDS or are restricted from buying lower-rated bonds.
"If you can figure out a way to package the insurance into the actual bond that just turns it into one security, then what you are doing is opening up the entire world of corporate bond investors to the use of a product that requires single-name CDS," said Dexter Senft, co-head of fixed income electronic trading at Morgan Stanley.
Investors and sellside competitors are generally curious and will be interested if the tool turns out to be economically efficient and liquid.
"We potentially would be interested in buying enhanced bonds because they offer the opportunity to adjust the risk in names that might otherwise fall out of our acceptable risk profile," said Richard Donick, chief investment officer at DCI.
Citigroup now has to find an issuer willing to embed the eBond language in bond documents. The argument that this could expand a borrower's investor reach is a hard sell, however, in a market in which US$7bn-plus book sizes are common.