Situations may arise whereby the prices of defaulted debt can soar to levels well above any reasonable recovery rate. When this happens, it can have broader neg- ative implications, as they may distort the fundamental valuations of defaulted assets, create problems with the physical settlement of derivatives contracts, and dent the confidence market players have in the instrument.
By contrast, the public market becomes increasingly standardized and features large granular portfolios. Not only is this market segment continuing to be rated, but also credit ratings are very important. Investors tend to be less sophisticated than in the customized market, and they rely on rating for risk assessment, as well as on pricing.
According to experts, liquidity plays a crucial role in the public market.
Therefore, understanding and measuring market liquidity with credit risk trans- fer instruments is extremely important for all market participants. Not only does the level of liquidity matter, but also its volatility and the pattern of how it evolves as a consequence of:
● Market-driven, and
● Regulatory-driven developments.
Concern about liquidity with CDOs, CDSs and credit derivatives in general may look a little strange because liquidity has been boosted by the use of derivatives (and by carry trade). CRT instruments may still have a negative impact upon liquid- ity, particularly under conditions of market stress. To appreciate this reference we must distinguish between:
● Search liquidity, and
● Systemic liquidity.
During relatively quiet periods, the liquidity premium is driven by search costs.
These are the costs incurred by traders and market makers in finding a willing buyer for an asset purchased, while the market maker/dealer is making markets in this asset. This is an asset-specific liquidity.
By contrast, systemic liquidity is linked to the degree of stress, if any, existing in a market. If all investors attempt to take the same positions at the same time, then the homogeneity of their behaviour will soak up liquidity. Disappearing sys- temic liquidity refers to negative liquidity conditions in the market as a whole.
Some experts suggest that the transfer of credit risk in portfolio form through synthetic CDOs and standardized CDSs can have a positive impact on systemic liquidity. Behind this opinion lies the hypothesis that portfolio instruments increase systemic liquidity by allowing a more general dispersion of credit risk across a diversified investor base. However, other experts disagree, saying that experience with these instruments is still in its infancy, and general statements are unwarranted.
More convergent opinions can be found regarding search liquidity. It seems likely that credit derivatives markets helped in reducing search costs by swamping
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hedging and funding costs. Until there is proof to the contrary, the prevailing opinion is that credit derivatives have the potential to:
● Boost search liquidity, and
● Strengthen the resilience of the corporate bond market to adverse events.
Support for the latter argument is provided by the use of plain vanilla credit derivatives in the aftermath of the General Motors and Ford credit rating down- grades in May 2005. At that time, in the aftermath of credit downgrades, corpor- ate bond investors effectively unwound their exposures to these issuers.
On 31 May 2005, General Motors’ and General Motors Acceptance Corp (GMAC)’s debt was transferred from investment-grade bond indices to junkland.
Curiously, however, spreads on Merrill Lynch’s high-grade American corporate index tightened, from 111 basis points over Treasuries in mid-May to 95. Spreads on junk bonds have also narrowed, by more.
Adding to the puzzle, GM’s benchmark bond due in 2033 was selling for more than it did before the downgrade. ‘The market has held up better than we expected,’ said Michael Fuhrman, North American head of electronic trading at GFI Group, an interbroker dealer in credit swaps. He added that: ‘Despite the tur- bulence, with moves five or six standard deviations away from what many models predicted, the CDS market enabled investors to transfer risk with no systemic problems.’10
This may be so, but it is no less true that a challenge facing regulators, and the market at large, is that the rapid growth in the OTC derivatives markets, of which credit derivatives have become a major segment, is not being matched by equiva- lent growth in investment in infrastructures for:
● Back office
● Risk management
● Clearing and settlement, and
● Servicing of the outstanding transactions until maturity.
The need to address infrastructural issues is made even more urgent from the point of view of their market positioning. Positions are used to offset the unwanted components of the risk with other market makers, but the more sophisticated the financial instruments, the greater the need for analysis and experimentation:
● Sometimes outstanding positions with other market makers often go in opposite directions, effectively cancelling each other out
● Even so, however, they still need to be kept in the dealers’ books and serviced.
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It is no secret that problems of extensive credit line utilization and of insufficient back-office capacity have been aggravated by credit derivatives. The issues such problems pose have to be addressed from different angles to satisfy the require- ments of all market players. Accountants can play a key role in the process of enabling senior management to be in charge, and a similar statement is valid about the role of technologists.
Notes
1 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis. Butterworth- Heinemann, London, 2004.
2 European Central Bank, Financial Stability Review, Frankfurt, December 2006.
3 The term used by the Basel Committee is ‘credit risk mitigation’ (CRM).
4 Which consist of large pools of CDSs.
5 EIR, 27 May 2005.
6 EIR, 14 October 2005.
7 The Economist, 1 July 2006.
8 Basel Committee, ‘Instructions for QIS5’. BIS, Basel, July 2005.
9 European Central Bank, Financial Stability Review, Frankfurt, December 2006.
10 The Economist, 18 June 2005.
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