(This article first appeared in the October 11 edition of the International Financing Review, a Thomson Reuters publication)
* DB scales back as new CDS launches
* Dealers feel pinch on leverage ratios
* Banks believe single-name activity will rebound
By Christopher Whittall
LONDON, Oct 13 (IFR) - Deutsche Bank has significantly scaled back single-name credit default swap trading in Europe as it struggles to meet regulatory hurdles on leverage. It is a move that is symptomatic of a wider malaise in a market wallowing in low volumes and spiralling costs.
As the market adjusts to trading a brand new CDS contract, participants say the industry giant is conspicuous by its absence in single names, capping off a two-year period that has seen an exodus of senior traders and a fall in market share in CDS trading.
Deutsche says it still makes markets in CDS products with a team of five traders in Europe, while emphasising it is trying to clear as many transactions as possible.
For uncleared CDS, such as the single-name market in Europe, the bank says its prices will reflect the economics of executing these trades - a decision that other firms say is tantamount to pulling back from European single-name CDS trading altogether.
“The current bid/offer in the uncleared European CDS market does not accurately reflect the economics imposed on banks under the new regulatory regime. We aim to be very strong in credit, but we need to adapt to the new rules,” said Suzanne Cain, head of credit sales at Deutsche. “We are leading the market to trading only cleared CDS across the board over time, as is the case in the US.”
The development comes at a watershed moment for the US$21trn credit derivatives market, as it coincides with the launch of new legal documentation for CDS. The new documentation, which is designed to ensure the product accurately reflects the economics of the bond market, is intended to consign bad CDS headlines to the history books and boost sagging volumes.
But it is the roll-out of the new CDS definitions that has exacerbated the difficulties for balance sheet-constrained dealers. Trading the new contracts alongside a legacy book of CDS will cause a bank’s leveraged balance sheet to balloon as the two instruments cannot be netted.
This is particularly painful due to a 5% CDS notional add-on for a bank’s leverage ratio, which can only be mitigated by clearing the product - a key plank of the G-20 financial reforms. Unfortunately, clearing for single-names is not expected to go live in Europe until mid-2015 at the earliest. The temptation, in the meantime, is not to trade the new contracts at all.
Deutsche says that clients can - and do - clear single-name CDS through US clearing house ICE Clear Credit. Other firms suggest that many European clients are reticent to clear ahead of time. Moreover, financials, high-yield, most sovereigns and all index options are not clearing in the US yet anyway.
Rivals concur with Deutsche’s view on the constraints facing CDS trading, but there is still a startling lack of consensus over the future of the business across the industry. Barclays is another CDS behemoth that is striving to hit regulatory targets on leverage, but does not think retrenchment is the right answer.
“We believe there are underlying positive trends from the client base. The economics are challenging right now, but you need to be there providing liquidity to your clients during this transitional phase for the credit derivative market,” said Adeel Khan, co-head of global credit trading at Barclays.
Still, Deutsche is hardly the only firm to make swingeing cuts in parts of its fixed income, commodities and currencies business as it grapples with boosting capital and leverage ratios.
There is a stark cross-Atlantic divide here. Discrepancies in local regulators’ measures of leverage - as well as US banks having less balance sheet-heavy set-ups for historical reasons (including the fact that they largely do not provide mortgages) - have put European banks at a distinct disadvantage when it comes to the leverage ratio.
Many believe the shrinking CDS business is a natural candidate for the chop. Single-name CDS rose to prominence with the structured credit boom, peaking at around US$32trn gross notional in 2007. As synthetic CDOs and monoline insurers have gone the way of the dodo, the amount of single names outstanding has shrunk by 65% to US$11trn.
Meanwhile, two high-profile bank nationalisations in the Netherlands in 2013 and Portugal this year that failed to trigger CDS payouts severely dented the product’s reputation, with volumes in financials suffering as a result.
But it would be wrong to say that retrenchment is the only game in town. Dealers say part of the fall in single-name trading is cyclical: the product is less relevant in a macro-driven world, and volumes are down across fixed income anyway. This is expected to reverse once the cycle turns, causing revenues to pick up, while the 2014 Credit Definitions are expected to provide another fillip.
“The fall in CDS volumes has coincided with a perfect storm over the past two years: a shift to clearing and e-trading, a bull run in credit and major changes to the CDS market,” said Tim Gately, head of European credit trading at Citigroup. “The new definitions enhance the transparency and effectiveness of the product and should help bring people back to CDS.”
There are also encouraging trends in the client base. Whereas single-name volumes were once dominated by the synthetic CDO machine and prop desks, users are now a more stable, and far less leveraged, group of investors.
“The volumes traded over time have migrated towards, and are now dominated by, traditional asset managers, who now have to manage their risk differently because the beta has disappeared from the market,” said Samik Chandarana, head of European credit trading at JP Morgan.
There have been notable areas of growth in the credit derivatives world too. Indices are now the most liquid product in the market for shifting large chunks of credit risk. Net notional outstanding of index options is US$169bn compared with just US$4.2bn in 2011. Total return swaps on iBoxx cash indices are taking off.
Single-name CDS is no longer the engine room in credit trading divisions. Dealers have now placed their bets on how pivotal a part of the business it will be in the future. Deutsche’s pullback makes its own view clear. (Reporting By Christopher Whittall, editing by Matthew Davies)