Chains, my baby's got me locked up in chains, And they ain't the kind that you can see…
- Carole King
The worst of the megabank-controlled market traps is the credit default swap (CDS) market. Unlike the interest rate swap market, where 90% of the sell-side of the American market is in the hands of four megabanks (over 90% by notional amount) - Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and JPMorgan Chase (JPM) - the CDS market is dominated by only three megabanks (over 96% by notional amount; Goldman Sachs drops off the list) according to the Comptroller of the Currency Derivatives Report (first quarter, 2017).
There are multiple sins associated with this market:
- Extreme sell-side market concentration.
- Events of default that result in buyer payoff determined by a committee that represents the dominant sell-side of the market. Most of the buys are sell-side positions, despite almost all the sells being theirs, interestingly.
- The underlying product (credit) that determines settlement values, is also dominated by the sell-side.
- The hedge funds that participate on the buy-side of the market are over-collateralized. Hedge funds provide margin collateral triple the asset value of their positions.
- The CDS market was the casino where AIG lost a multibillion-dollar bet to Goldman Sachs at the apogee of the Crisis.
This article argues that this market is so fraught that - unlike other markets I cover, such as interest rate swaps, securities lending, and foreign exchange - there is no way to provide this market with integrity. When three parties control the sell-side of the market, dominate the buy-side of the market, charge triple collateral to the second-largest group of participants (the hedge funds) at governmental behest, and comprise the committee that decides whether buyers or sellers are paid on every trade, what business do the rest of us have participating at all?
Matt Levine of Bloomberg provides an entertaining and enlightening description of an event that reveals the vulnerability of the CDS market to the trade group that represents the sell-side, the International Swap Dealer's Association (ISDA). The event was a transaction between Noble Group (OTCPK:NOBGY), a troubled commodity trading firm partially owned by the Chinese Government and listed in Singapore, and its creditors, reported here.
In Levine's words,
Noble Group Ltd. had a credit facility that came due in June, and it asked its banks to extend the maturity for four months until October, and they agreed, averting a default on its debt. Or not averting a default? What is a default, anyway? … But what if you had bought credit-default swaps on Noble?... people who bought Noble CDS think that there was a default, and people who sold Noble CDS think that there was no default, and so they went to the International Swaps and Derivatives Association's Determinations Committee to ask for a ruling. The committee punted, deciding 'that it currently does not have sufficient information that is public or that can be made public to determine the Restructuring Credit Event DC Question one way or the other,' in part because no one sent it a copy of the amended credit facility."
This is a royal flub-up. It shows the convoluted conflicts of interest that cloud the CDS market. Let's say you are a megabank that sits on the ISDA's Determinations Committee. If you are the buyer of a Noble CDS, you will want to call this refinancing a change in the terms of the credit extended to Noble. You can have your cake and eat it too, by extending credit at altered terms, while encouraging the ISDA to call it a default.
There is little chance that the government of China is going to want this company to fail on its debt. Although the optics of Noble's performance are ugly, and commodities dealing not the safest of businesses, you can see yourself continuing with this scam indefinitely.
So, let's say you sit on the ISDA and that you've bought a Noble CDS, after participating in the loan to Noble. What fun!
You encourage the ISDA to declare a default event - triggering payment to your CDS position, based on your loan syndicate's decision to refinance the loan. Yet, after collecting on the swap, you are still participating in the loan, albeit at better terms. That loan is now priced as though the Noble is a troubled firm.
[But you just made a bundle selling CDS swaps on Deutsche Bank (DB), when the world was foolishly paying up for DB CDS swaps because the "market fundamentals" said DB was going to come a cropper; but you said to yourself. "Self, this is the largest commercial bank in Germany. No way is Germany going to allow a DB CDS to default." And thus, it was.]
Now you consider your CDS options. While most of the investment world is cranking up the quants to figure out the theoretical option value of the CDS, you make a few discrete phone calls to other ISDA members, to decide whether the next time Noble blows up, the ISDA wants to declare another default or not. After those conversations, you decide whether to buy or sell. And the fun begins!
But this fun is far from over. Remember, Noble is a commodities trader; you, their loyal, long suffering, banker. What would be a real picnic is to ask Noble to provide regular position reports. Would it not be overstepping your bounds to ask for regular reports of their positions? No. Only reasonable.
Let's say Noble is long gold futures. Perfect. You short those same gold futures. This is not illegal, or even rude. It is simply an indirect hedge of your credit risk to Noble. Of course, it's also a bet against Noble's trading expertise. But, short of some sort of fraud or other highjinks at Noble, you have protected your loan principal. Your loan interest will come from commissions paid to Noble by its brokerage customers.
If nothing further goes wrong at Noble, you've got a capital gain on the loan, plus interest consistent with high risk. If you bought the CDS, you and your friends at ISDA lose as the swap expires. If you sold, you add the CDS premiums to the interest income and capital gains on the loan.
To sum it all up, you are betting on the belief that the Chinese Government will not let Noble fail; against global counterparties that are betting on the technicalities of CDS pricing, based on the financials of a risky commodities trader working the Asian markets. As with your earlier wager on DB CDS, I like your odds.
In the CDS market, three megabanks control the entire sell-side of the market, most of the buy-side, and the credit that is the underlying deliverable on this derivative instrument. Finally, these megabanks control the decision to pay or not to pay the CDS buyers. Do you believe the hedge fund managers that constitute most of the rest of this market are really the smartest guys in the room?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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