The issue of liquidity in CDS has been many people’s minds of late, myself included. This piece from FT Alphaville, written by Gavan Nolan at Markit, is exceptional. First, we have the ways market liquidity in CDS can be measured:
- Bid/ask spread data (observed/calculated)
- Number of dealers quoting (based on dealer runs)
- Number of quotes each day (based on dealer runs)
- Markit composite depth information from Markit’s end-of-day service
- A liquidity score per reference entity-tier
These are all important indicators in determining liquidity. I, along with other folks, have talked about liquidity issues in the CDS arena before:
But isn’t the 83.7% of trading by dealers “real”? If there are only 6 firms in the United States controlling the credit derivatives market and slightly more than that internationally, how can that be “real”? Since CDS positions are a zero sum game, all dealers combined can only be net long what non-dealers are net short, and vice versa. Just as in the used car analogy, we care only about the trading by retail car buyers, not the movement of volume between dealers, who still need to sell whatever cars they buy en masse. Moreover, we want as many price points from retail car buyers as we can get, so we want the www.kbb.com Kelly Blue Book prices, not the prices from one dealer’s lot.
My hope is that the data from Markit will begin to get at the heart of some of these issues. It looks like it will because a bunch of that data will show market breadth and depth. Which many folks believe to be shallower than a kiddie pool.
But there’s also some disturbing – but expected – trends we see taking shape:
However, if we look at the bid/ask spreads this week, we can see that they have widened dramatically. This is to be expected – the CDS spreads of all five countries have widened sharply. But the expansion of the bid/ask spreads outpaces the widening in CDS spreads.
Why? Call this a consequence of the BaFin ban. And I don’t think it was unintended. Indeed, as the Alphaville piece continues:
It is also evident that there was a big jump in the bid/ask spreads on May 19. This was after the German regulator Bafin announced a ban on naked CDS referencing eurozone sovereigns. The move created some uncertainty in the market and appears to have led to a disruption in liquidity. Overall, the disproportionate widening in bid/ask spreads in recent weeks suggests that liquidity has fallen.
This is just more of the same government heavy handedness directed at symptoms instead of diseases. Don’t like reading about CDS quotes screaming higher on a day-to-day basis? Ban their use; that will sort it all out.
Because as I pointed out before, viewing CDS strictly as “insurance” is wrong:
Liquid credit indices are just like liquid stocks. You can buy/sell them in size, and pay very little for the privilege. Illiquid credit protection, however, is a whole other ballgame. You can’t get in/out of positions easily even in good times and you’re going to pay through the nose to do it. And if you try to do a trade in size? Puhleeeze…
This also illustrates why it’s laughable to think CDS have anything to do with making the sovereign credit situation worse. These are synthetic shorts when you buy them. If they didn’t exist, there would only be one option: sell the cash bonds and watch the yields & spreads blow out even higher than where they are.
So what are we going to be in for? Most likely, reduced liquidity in the market.
And with reduced market liquidity, we get things like this…