5 Ways to Fix Broken CDX Indices
It is bordering on shameful that more than four years after Bear Stearns, so little progress toward exchange-traded CDS has been made.
1. Exchange Trading
Force all the indices onto exchanges with standard collateral provisions. It will be hard to avoid some off-exchange trades, but this would be a big step in terms of controlling size and creating transparency. Have "margin" a function of the "worst of" mark-to-market and fair value. That would ensure that those hurt by the market price are paying appropriate collateral, and those at risk to a snap back to fair value (which happens regularly, and usually quickly) also have appropriate collateral. It is bordering on shameful that more than four years after Bear Stearns, so little progress toward exchange-traded CDS has been made. Even clearing and swap execution facilities seem to be taking far longer than they should.
2. Right to Convert to Single Names
As much as these are called "indices," they really are portfolio trades. The document reads exactly as 125 single-name contracts. In the original TRACERS, which was a 40-name Morgan Stanley (MS) product, you had the right to convert to single-name trades. With the SNAC (Standard North American Corporate) protocol, the risk of doing this is less than it used to be. It would ensure that the index stays in line with fair value. It would let people "collapse" the arb, where they bought index and sold single names (or vice versa). That would let a lot of trades drop out of the system, reducing counterparty exposure and complexity at the same time. If it looks and acts like a portfolio, it is, so why not look at putting this old "feature" back in. It comes with some risks, but if the index and single names are all exchange traded, it actually works very, very well.
3. Market-Weighted as Opposed to Equal-Weighted Indices
The CDX indices are equal weighted rather than market weighted as most traditional indices are. That means names like MBIA (MBI) and Radian (RDN) make up a disproportionate amount of the CDX index relative to their importance to the bond market as a whole. When indices contain a big concentration of poorly followed but dangerous names, their tendency to deviate from "fair value" increases, since those names drive fair value the most and are not that liquid. For all the "complaints" about ETFs, I hear that real money clients like them because they better reflect the makeup of their portfolio than the equal-weighted CDS indices do.
4. Make It a Proper Index With Name Replacement Rather Than 'Rolls'
The S&P 500 has changed at least 20% of the names since Lehman Brothers, yet it is still called the S&P 500; people run historical models based on the index as it once was. It performs like an index. Here we have IG1 still around in "10 years," which is a March 2014 index, all the way out until IG18. It seems ridiculous. The industry has figured out an "auction" process for Credit Events, so maybe it can figure out a process to "replace" names in the index rather than "rolling" it. Name changes aren't that common, and a process to get single-name positions on the names coming out could help that. It would be hard for tranches, but frankly, who cares that much about synthetic CDOs at a regulatory or systematic level? This is the hardest evolution, but should occur, or at least be looked at.
5. Futures on Bond Indices or ETFs
Is that the next evolution? Diminish the importance of CDS by creating viable, tradable futures contracts on bond indices or ETFs?
Editor's Note: For more from Peter Tchir, check out TF Market Advisors.
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