Credit-Default Swaps

September 28, 2011

（Prof. Hong Yan talked in an article on the Wall Street Journal. He pointed out that it could be potentially dangerous that CDS spreads are often quoted as readily as the DJ industrial average nowadays. ）

A Fear Gauge Comes Up Short

--- Analysis Shows Credit-Default Swaps, a Popular Indicator of Market Health, Are Thinly Traded

Wall Street is glued to a gauge of trading fear that has surprisingly few trades behind it.

 In recent years, credit-default swaps -- contracts that give the buyer the right to collect a payment from the seller if a borrower defaults on its obligations -- have risen from obscurity to an avidly tracked barometer of the financial health of everything from Bank of America Corp. to Greece.

In some cases they have even come to serve as a stand-in for stock quotes when U.S. exchanges are closed.

Before stock markets opened in New York on Aug. 23, for example, the price quoted for the cost of insuring against a default on Bank of America rose sharply, hitting a record high. A Nomura Securities trader sent out an email alert citing the derivatives price: "Ugly out there this morning."

Yet a Wall Street Journal analysis shows that actual trades in these widely cited derivatives are few and far between -- and the quotes that market observers bandy about often aren't based on actual trades at all.

While the swaps can help investors’ hedge risks and bet on market trends, the thin trading underlines a key shortcoming of an instrument that has a huge influence on risk perceptions. During periods of stress, the actions of a few traders can have an outsize impact on delicate market psychology.

"The market does not fully understand the limitations in trading, or the lack of liquidity, as CDS spreads are often quoted as readily as the DJ industrial average nowadays," said Hong Yan, a professor of finance at Shanghai Advanced Institute of Finance who is on leave from the University of South Carolina. "This could be potentially dangerous in a very volatile and uncertain market since CDS spreads are used much more frequently and prevalently."

The Journal analyzed data compiled by Depository Trust & Clearing Corp., a central warehouse that collects swaps trading information from investment banks. That analysis shows that even for the most popular credit-default swaps, such as those for Bank of America debt, daily trading is dwarfed by that in the stock market and often, too, in bonds.

For the week ending Sept. 16, the most recent data available, the gross notional value of swaps referencing Bank of America -- that is, the value of the contracts outstanding -- rose from the prior week by $700 million, according to Depository Trust.

By comparison, some $8.5 billion of the Charlotte, N.C., company's stock traded during the same week.

Despite the thin trading, investment banks and media outlets frequently point to swaps pricing as an indicator of the health of the global financial system's constituent parts.

On Tuesday, the limited trading was further highlighted in a Federal Reserve Bank of New York paper that analyzed three months of swaps data for both single-name corporate bonds and baskets of swaps. New York Fed officials sought to better understand how frequently the derivatives trade amid regulatory efforts to require investment banks to report real-time transaction data.

The study found little actual trading.

"A majority of the single-name reference entities traded less than once a day, whereas the most active traded over 20 times per day," the New York Fed paper said.

"The CDS market, in general, is not like the fast-trading stock market," said Darrell Duffie, a derivatives expert and finance professor at Stanford University.

That isn't to say there is no money at stake in the credit-default swap market. The net notional value of swaps outstanding on Bank of America, for instance, was $5.8 billion at Sept. 23, a similar level from the start of the year, according to Depository Trust. That is the maximum amount of money that would be exchanged in the event of a default.

The contracts have been used for years by banks to unload risks they don't want and by hedge funds and other investors to bet on changing market trends. But since the financial crisis of 2008, they have been best known as a measure of market stress.

In the case of credit-default swaps for corporate bonds, a buyer pays a sum quarterly for the derivative. If a bond defaults, the losses are covered by the seller of the contract.

Costs of the protection can rise if investors believe the underlying debt is getting riskier. Those trading the swaps often are big banks or, to a lesser degree, hedge funds.

Data vendors such as Markit Group Ltd. and CMA, a unit of CMA Group, use computer systems to extract swaps prices -- including quotes -- from electronic messages between investment banks and investors.

The companies aggregate that pricing data, which makes its way to a wider audience seeking a gauge of default risk -- an audience that may not recognize the limitations of the data they are looking at and the nature of how the derivatives trade.