Deconstructing the CDS Market: Counterparties, Their Trades, and the Residual Risks in the System
With credit default swaps back in the news, we build a virtual CDS world to explain how the market works.
What I will attempt to do here is build a CDS world for you. We will look at various counterparties, the trades they do, and the residual risks in the system. It will be loosely based on Greek CDSs but some liberties will be taken. None of the institutions are real-world institutions (in spite of how much they sound like some we know). It is a simplification, but to make it useful, it has to be robust enough to give a realistic picture of the CDS market/system.
Hedge Fund 1 (HF1) is a large global macro fund with a strong presence in the credit market. HF1 is a very sophisticated trading operation with good ISDA Master Agreements (ISDAs) with all the market makers (MMs).
Hedge Fund 2 (HF2) is more of a bond-focused account that uses CDSs primarily as a hedge and for some basis trades. They only have ISDAs with Market Maker 1 (MM1) and Market Maker 2 (MM2). HF2 didn't bother dealing with Market Maker 3 (MM3) because they felt that MM3 mostly tried to broker orders and offered no real value.
Hedge Fund 3 (HF3) is an aggressive trader of CDSs (and bonds). When not busy begging for new issue allocations to flip they focus on ensuring the market is "efficient." They trade high volumes, but in spite of their efforts to ensure the markets are efficient, they're sometime ridiculed as "spivs" (special purpose investment vehicles). They have ISDAs with all the MMs but generally on terms move favorable for the MMs.
MM1 is the best and most sophisticated of the money center banks acting as market makers for CDSs. MM1 also has an active bank hedging book that hedges their exposure to counterparties, either from loans or derivative trades. This hedging book is restricted to trading internally and cannot source risk from outside the bank.
MM2 is a decent market maker. Not quite as good or as sophisticated as MM1, but decent. They have a bank hedging desk as well, but since MM2 is not a great market maker, they are covered by MM1 and MM3 as clients (while the trading desk is a competitor of MM1 and MM3); definitely a hedge fund-oriented strategy, which has some appeal since hedge funds trade far more actively.
MM3 is the weakest of the market makers. They always seem to be a step behind, but they have some strong relationships with a couple of small, weak banks in their domestic market. They can still make money on these "captive" clients while not being as good as MM1 and MM2.
Small Bank 1 (SB1) is a good, well-managed small bank. They typically make loans or buy bonds and use CDSs as a hedging tool, but will occasionally sell CDSs as a way to "enhance" returns. SB1 is big enough and aggressive enough that it has ISDAs with all the MMs and on pretty good terms in regards to collateral.
Small Bank 2 (SB2) is similar to SB1 but only has ISDAs with MM1 (because they are the best) and with MM3 (because they feel a close connection to the bank that is big in its own domestic market).
Small Bank 3 (SB3) is the weakest of the banks. Capital is always tight. Access to funds is tight. They rely on accrual accounting and aggressive regulatory capital treatment. They only have an ISDA with MM3 because MM3 is the dominant player in their domestic market, and MM1 and MM2 had demanded much harsher and "unfair" terms during ISDA negotiations, so they had never been finalized.
Mutual Fund 1 (MF1) rarely uses CDSs, but occasionally will use them to hedge or take risk. They have ISDAs with all three dealers in spite of the fact that they rarely use them.
Insurance Company 1 (INS1) also rarely uses CDSs, but only set up an ISDA with MM1 because they got good enough execution with them. And for how little they use CDS, it didn't make sense to set up more and manage more.
The "Street" consists of non-risking-taking brokers who only talk to market makers; market makers show prices to the Street as well as to clients – not always the same or at same time.
Let the Trading Begin
After a series of trades (assuming each one is for 10 units), the market now looks like this.
2. MM2 tries to find a seller of protection to cover their risk, so they put a bid out in the Street. MM3 knows that their "captive" client SB3 is looking to sell protection on this name, so MM3 sells protection to MM2.
3. MM3 then buys protection from SB3.
Net notional is 10 with HF2 short 10 or alternatively SB3 long 10. Gross notional is 30 as 3 trades are outstanding.
Green Trades and Purple Trades
5. This is the leg of the curve trade where HF1 sells five-year protection (HF1 has ZERO net notional exposure yet would still post collateral with MM2 since the spread could move, but far less collateral than if they were outright short).
6. SB1 is looking to buy protection, and when they see MM2's new aggressive five-year-protection offer (they had just bought protection from HF1), they engage with MM2 and buy protection from them.
7. MM2 now wants to cover the two-year leg of the trade as well. They go out aggressively to customers trying to buy two-year protection. They don't show it to the Street as two-year is relatively illiquid and they don't want to push the market against them. HF3 notices it is very aggressive compared to a two-year market sent out earlier by MM1 (actually their "run scraper" notices it is aggressive and sends an alert to the trader that there is an "arbitrage" opportunity). Sure enough, MM1 is willing to stand up to their earlier offer on two-year CDSs, so HF3 buys two-year protection from MM1.
8. HF3 turns around and sells protection to MM2 "on assignment" with MM1. So HF3 will do a trade with MM2, but assign them to face MM1. HF2 will have no trades on the books but will have received a payment equal to the difference they crossed the market makers for. (And you wonder why some hedge funds like the market as opaque as it is.) Some market makers are better at checking same-day assignments than others in an effort to stay away from clients that "pick them off."
9. This is the resulting trade in the system after trade eight and the assignment in trade nine. There is a formal assignment process and MM1 and MM2 have to accept each other as counterparty – ie, HF3 doesn't dictate who anyone faces, they merely "request" they face each other. In normal times, market makers accept virtually all assignments as they manage the counterparty exposure closely and are comfortable with other market makers. Any time you hear that some market makers won't take other market makers on assignment, that is pretty much the end of that ostracized market maker (it happened with Bear Stearns and with Lehman Brothers).
Net notional is now 20 with HF2 short 10 and SB1 short 10, or alternatively because SB3 is long 10 and MM1 is long 10 as well. Gross notional is 70 (there are seven trades outstanding; trades don't exist).
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