How the CDS Market is Going to Improve

A Credit Trader has a great post on what he calls "risky annuity risk", an artifact of the CDS market which will go away when all credit default swaps start trading on a fixed coupon. If you like to geek out with the arcana of the CDS market, you’ll love this.

Let’s say you’re a CDS trader who buys $50 million of 5-year default protection on General Motors at 100bp. That means you pay 100bp per year — $500,000 — in return for getting a big payout should GM default at any point in the next five years. Six months later, GM is looking much riskier, is trading at 300bp. You decide to take your profits, so you sell $50 million of 4.5-year default protection at 300bp. You’re now receiving $1.5 million a year, and paying out $500,000 a year, for a net profit of $1 million a year over the next four and a half years. Which adds up to $4.5 million. Well done! You book your $4.5 million profit, and celebrate with some fine Champagne.

But then GM defaults. This is not good for you. Yes, you’re perfectly hedged when it comes to default risk: the amount you owe to the person who bought protection at 300bp is exactly the same as the amount that the person who sold you protection at 100bp owes you. Assuming no counterparty risk, you’re flat, and there’s no problem there. The problem is that your $1 million-a-year income stream has suddenly gone dry. The CDS have all been wound up: you’re not paying $500,000 a year any more, and you’re not receiving $1.5 million a year any more, either. And your $4.5 million profit has disappeared.

This is what ACT calls "essentially unhedgeable jump-to-default risk" — you bet on a credit souring, the credit sours, you make lots of money, but then you hope desperately that the credit doesn’t sour all the way to a credit event, because then you lose most of the money you thought you’d made.

The solution to this problem is to set the coupon on all CDSs at, say, 100bp. In that case, the first deal is exactly the same: you’re the protection on $50 million notional of GM debt at a spread of 100bp, and you pay out your $500,000 per year. But when you come to close out the deal, instead of selling protection at 300bp, you sell protection at the same fixed spread of 100bp. Since GM credit default swaps are trading at a spread of 300bp, however, you’re essentially selling the exact same contract that you entered into six months previously — you’re selling the privilege of being able to pay just $500,000 a year in return for that big payout if GM goes bust. How much is that privilege worth? $4.5 million.

The CDS has become a tradeable instrument, which goes up in price when spreads widen, and which goes down in price when spreads narrow. The buyer of protection always pays the seller $100,000 a year for every $10 million nominal amount, and the seller of protection pays the buyer an up-front sum if the spread is below 100bp. Conversely, if the spread is above 100bp, then the buyer of protection pays the seller an up-front sum.

By moving to this system, CDS traders manage to get rid of that pesky jump-to-default risky annuity risk, and can cash in their gains as soon as they close out their positions. Liquidity in the CDS market should improve, bid-offer spreads should narrow, and volumes should rise. Of course, that’s exactly what all those people who want to move to exchange-traded CDSs want, right?

Update: Alea, in the comments, corrects my misconceptions about how the new system will work: apparently the annual premium will be a thing of the past, and the whole premium will be payable upfront. Which means that the buyer of protection always pays an up-front sum, no matter what the spread.

Update 2: Wait, no, that’s not it, either, the buyer of protection still pays an annual premium, and then there’s an upfront payment as well. Isn’t that what I said the first time? Look, here you go, Markit explains it all in great detail. Look at pages 15-16.

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