The credit default swaps (CDS) market has declined dramatically since the financial crisis. Trading volumes in CDS—which are financial swap agreements in which the seller agrees to compensate the buyer of the CDS in the event of a loan default—are a mere one-fourth of what they were in 2008, totaling less than $9 trillion in amount outstanding nationally as of June 2015.
What is the cause of the substantial drop in the CDS market, and what can be done to bring it back up?
A report titled “Can the Credit Default Swap Market be Salvaged?” from the Kroll Bond Ratings Agency (KBRA) states that new laws and regulations focused on reducing the risk of over-the-counter (OTC) derivatives products is partly to blame for the dramatic decline. But KBRA also said in the report they believe the decline is “part of a larger trend by large, systemically significant global banks to move away from products and markets that are seen as problematic.” Raising some troubling questions for both borrowers and investors is the settlement agreed to by some of the world’s largest banks regarding accusations of conspiracy to limit competition in the credit derivatives market, KBRA said.
The secular decline in CDS trading raises the question as to whether the declining trend in credit derivatives trading since the crisis will be reversed—or if it can be reversed, according to KBRA. Currently, many nonbanks are entering the OTC credit derivatives market as large banks exit the space, and the nonbanks are offering trading products and clearing services that directly compete with commercial banks, according to KBRA.
A number of defects remain in the market structure of OTC credit derivatives despite significant changes in regulation, and these defects have arguably intensified the effects of the 2008 crisis and become a disadvantage to both investors and borrowers, KBRA said.
These defects in the market structure of OTC credit derivatives:
- Limit competition
- Make it difficult for investors to understand the risks that large universal banks take
- Create the potential for manipulation of borrower credit spreads
- Affect recognition of when defaults under CDS contracts occur
The “obvious” potential conflict between the banks’ role as lender/underwriter of the securities on one hand and credit derivatives trader on the other is one of the most important but also one of the leas talked about structural defects in the CDS market, according to KBRA.
“When large universal banks act as both providers of credit and dealers in CDS, there is obviously the potential—if not the reality—for conflict,” KBRA stated. “This dual role gives CDS dealer banks both the incentive and the means to use CDS to manipulate the worldwide price and allocation of credit.”
The simplest ways for Congress and other regulators to address the remaining structural defects in the CDS market are, according to KBRA:
- Prohibiting cash settlements of credit default contracts
- Require that all CDS exposures be brought back “on balance sheet” with enhanced disclosure
“We also believe that Congress and prudential regulators need to look at the potential for conflict of interest when large banks act as both lenders and dealers in securities and CDS,” KBRA said.