The bankruptcy of Detroit brings new pressure on municipal bond investors and related exchange-traded funds like (HYD) (NUV) (PML) (PZA) (IIM) (NIO) (VMO) specializing in municipal bonds to heighten risk management and to hedge where appropriate. One potential tool in that regard is the single name credit default swap market, which is featured almost constantly in discussions of municipal entity credit risk. A recent example is "Traders Find Short Bets on Puerto Rico a Challenge," a Wall Street Journal blog. The author notes:
"Default insurance on Puerto Rico, sold in the form of derivatives called credit-default swaps, is available from few dealer banks. The contracts also have barely traded because the protection is not available to buy in meaningful amounts and disclosures from the Commonwealth have been limited, some market participants said."
The purpose of this blog is to bring clarity and precision to discussions of municipal credit default swaps by providing facts from the Depository Trust & Clearing Corporation trade warehouse. It is simply not the case that Puerto Rico credit default swaps have "barely traded." The DTCC data makes clear that Puerto Rico credit default swaps have never traded in any week since the DTCC began reporting weekly on trading volume beginning with the week ended July 16, 2010. In fact, only ten municipal or sub-sovereign names have ever been reported as trades to the DTCC trade warehouse during the 2010-2013 period. This note explains the details.
Municipal Credit Default Swap Analysis
Kamakura Corporation has been reporting semi-annually on the credit default swap trading volume reported by the DTCC. The most recent report from Kamakura Corporation analyzes the trading in 1,179 reference names in the 181 weeks ended December 27, 2013. Today's analysis is an update of the August 15, 2013 Kamakura Corporation report on weekly credit default swap trading volume for sub-sovereigns and municipals among 1,144 reference names that had traded in the 155 weeks ended June 28, 2013. The study found, unfortunately, that (in the words of Gertrude Stein) "there is no there there."
The data used in this study consists of CDS trades reported by Depository Trust & Clearing Corporation ("DTCC") during the 181 week period ending December 27, 2013. The weekly trade information is from the Section IV reports from DTCC. The data is described this way in the DTCC document "Explanation of Trade Information Warehouse Data" (May, 2011):
"Section IV (Weekly Transaction Activity) provides weekly activity where market participants were engaging in market risk transfer activity. The transaction types include new trades between two parties, a termination of an existing transaction, or the assignment of an existing transaction to a third party. Section IV excludes transactions which did not result in a change in the market risk position of the market participants, and are not market activity. For example, central counterparty clearing, and portfolio compression both terminate existing transactions and re-book new transactions or amend existing transactions. These transactions still maintain the same risk profile and consequently are not included as 'market risk transfer activity.'"
As always, our emphasis is not on gross trading volume. As of January 10, 2014, dealer-dealer volume was 72.48% of the single name credit default swap market and it would be nearly costless for dealers to inflate gross trading volume by trading among themselves. Instead, we focus on "end user" trading where at least one of the parties to a trade is not a dealer. Accordingly, we make the following adjustments to the weekly number of trades reported by DTCC for each municipal and sub-sovereign reference name:
- We divide each weekly number of trades by 5 to convert weekly trading volume to an average daily volume for that week.
- From that gross daily average number of trades, we classify 72.48% of trades as "dealer-dealer" trades, using the average "dealer-dealer" share of trades in the DTCC trade warehouse as of January 10, 2014.
- The remaining 27.52% is classified as daily average "non-dealer" volume, the focus of the reporting below.
Daily Non-Dealer Trading Volume for Municipal and Sub-Sovereign Reference Names
Of the 1,179 reference names for which DTCC reported credit default swap trades in the 181 week period, only 10 were sub-sovereigns of any type. This list is unchanged from the prior Kamakura report:
- Hong Kong Special Administrative Region
- State of California
- State of Florida
- State of Illinois
- State of Michigan
- State of New Jersey
- State of New York
- State of Texas
- The City of New York
- The Commonwealth of Massachusetts
There is no "Puerto Rico" on this list. The only other traded entities with "commonwealth" in the name are the Commonwealth of Australia and the Commonwealth Bank of Australia. The only entities with "Rico" in the name are Credit Agricole and Ricoh. This contrasts with the daily trades in the bonds of various Puerto Rico entities featured in this recent study. Note also that there is no Detroit entity on this list and not a single one of the California cities that have recently declared bankruptcy.
The distribution of the daily average non-dealer trading volume in these 10 municipal entities, using the weekly averages over the 181 week period, is given in this simple histogram:
Nine of the 10 reference names were in the United States and 8 of the 10 reference names were U.S. states. The only cities on which credit default swaps had any trades in the 181 weeks ended December 27, 2013 were the City of New York and Hong Kong. We can summarize the trading volume in these 10 reference names as follows:
- The highest ranking reference name in terms of trading volume was the State of California, which ranked only 780th of the 1,179 reference names reported by the DTCC.
- The median number of non-dealer trades per day on all 10 reference names over the 181 week period was 0.18 trades per day.
- Conditional on trades taking place, Hong Kong dollar volume was the highest at $8.8 million, but trading in Hong Kong took place only once, during the week ended July 16, 2010.
- The highest number of gross trades in one week was 173, which is the equivalent of 34.6 gross trades per day and 9.52 non-dealer trades per day. This data is for the State of California in the week ended September 21, 2012.
Over all of the weekly observations for the 10 entities on which trading was reported, the daily average trading volume is shown here:
The week by week gross trading volume (number of contracts) for the State of California over the full 181 week period ending December 27, 2013 is given in this chart:
The weekly totals for gross notional principal trading in the State of California is shown in the next graph:
In spite of the readily available DTCC trading volume data, journalists and data vendors persist in implying there is actual trading volume in municipal reference names when in fact there is zero trading volume. On Friday, January 31, the following message was sent by CMA, a rating agency affiliate:
The message gives one the impression that there is trading in the Port Authority of New York and New Jersey, and yet there has never been a trade in credit default swaps of this reference name since DTCC began weekly reporting in the week ended July 16, 2010. Pricing indications with no disclosure of the related trading volume is a warning signal that no sophisticated market participant should ignore.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.