Exchange-Traded Credit Default Swaps ?
I would vote for that but will be difficult. For a spread, there is more than one price and for a price there is more than one spread.
The price of a CDS is always uncertain. There is no single answer, CDS trade on “spreads” but the price depends on models and inputs. To quote a famous textbook exemple, suppose that you bought protection on Marconi at 250 bp sometimes in the late 90s, in 2001 the spread had widened to 4000 bp. You are rich or so you think. The unwind price depends entirely on recovery assumptions, at 30% recovery you would get 51% of par, at 99% you would get 1% of par, that is you would “lose” even though you got the scenario right.
Felix Salmon: Moving Towards Exchange-Traded Credit Default Swaps
A Wish List for Fixing Wall Street
May 13th, 2008 at 9:51 am
This is an issue but not an unsolvable one. The market already uses standard recovery values for various secotrs. Fixing the recovery value on the exchange is easily done and would solve the problem most of the time. Things could get weird if recovery assumptions change a large amount or when a company actually defaults and a recovery is realized. The exchange traded CDS would still have meaning you would just have some extra calculation to do to adjust for the difference in recovery value. That makes for a much less clean hedge and would hurt liquidity. However cleaning up the netting of swaps is arguably worth working out all the kinks.
May 13th, 2008 at 10:23 am
Bill:
I was very bullish on that at one time.
4 exchanges have tried so far and all failed.
Using a standard recovery value doesn’t solve anything, that’s exactly why you are better off doing a new CDS to exit a position rather than unwind an original position using a standard model/inputs. The CME tried binary CDS but the fact that recovery is fixed at the outset doesn’t stop the binary CDS from being very dependent on estimated recovery values, even more so than for plain vanilla CDS.
May 13th, 2008 at 12:32 pm
Standard recovery values do solve something. They let you put an exact dollar value on your swap. You can turn that value into any spread want to with any model you want, but everyone will agree on how much they will pay for the swap at the market spread. That might be very valuable to some parties.
Offsetting the swap is not obviously better. Doing an offsetting CDS leaves you with default risk, you now own an annuity that stops paying if the reference defaults. Unwinding the original swap leaves you with no risk at all, just cash in your pocket. Offsetting the swap leaves you with counterparty risk, a hot topic these days. Unwinding the swap doesn’t have that problem.
I remember a couple years ago JPM was trying to sell off their residual interest strips from offset CDS positions as structured securities, evidently they didn’t want to keep these things on their book.
All I’m saying is you can make an argument the value of an exchange is worth all these technical hassles. My opinioin doesn’t matter unless enough people agree with me.
Don’t forget that an exchange needs Wall Street’s support to get up and running. I’ve never talked a market maker that liked the idea, they love the CDS market the way it is, relatively opaque and wide.
May 13th, 2008 at 2:44 pm
How can you trade an option on exchange when the underyling doesn’t trade? Wthout a hedge mechanism, I don’t see how CDS can trade on an exchange.
May 13th, 2008 at 11:55 pm
[...] 14, 2008 Alea and Felix have both brought up the slow process of moving CDS trading to exchanges. The primary [...]