Sunshine Is the Best Disinfectant: Post-Trade Transparency in Credit Default Swap Markets

The International Organization of Securities Commissions (IOSCO) has released its final report on post-trade transparency in the credit default swaps (CDS) market. This is an interesting topic given the controversy surrounding credit default swaps and their role in exacerbating the 2008 financial crisis.

After the crisis, several jurisdictions implemented mandatory post-trade transparency for swaps markets — the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) in the United States are two of the better known examples. Post-trade transparency rules were also adopted in several provinces in Canada, while in the European Union, post-trade transparency rules for all nonequity markets (including credit derivatives) form a central element of the upcoming Markets in Financial Instruments Directive (MiFID), which enters into force in January 2017.

The IOSCO report looks at the impact of these mandatory post-trade transparency requirements in the over-the-counter (OTC) CDS market. Some interesting statistics come out of this report, including:

• Gross notional amounts of CDS at the end of 2014 were approximately $16 trillion. According to a separate Bank for International Settlements semi-annual survey from December 2014, gross notional principal has fallen dramatically since its peak in 2007 of about $60 trillion.
• Gross market value of CDS was approximately $593 billion and net market value of CDS approximately $136 billion at the end of 2014.
• Approximately 30-40% of CDS contracts by gross notional were types required to be reported to a swap data repository.
• The net market value as a proportion of gross market value fluctuated between 26% and 21% since 2011. This measure reflects the extent to which CDS positions are netted out between counterparties.

The pros and cons of transparency in the CDS market are similar to previous debates with securities markets. On the one hand, transparency may improve price discovery and improve market quality by increasing price competition. Liquidity and valuations may also improve as a result of more timely and accurate market information being available. On the other hand, increased transparency may reduce liquidity if hedging costs increase as a result of the dissemination of the hedger’s intentions to the market. The costs of developing, implementing, and maintaining a system of post-trade transparency are also significant and these costs may be passed on to market participants. Calibration of transparency provisions must therefore balance investor needs for greater information with adequate protection to dealers whose positions may be more exposed to opportunistic traders.

The report uses data generated as a result of the CFTC’s mandatory post-trade transparency rules as well as publicly available data from the Depository Trust and Clearing Corporation Trade Information Warehouse (DTCC-TIW). This enables a comparison between CDS that fall under mandatory post-trade transparency rules and those that do not. Swaps subject to the jurisdiction of the CFTC include CDS referencing broad-based indices while CDS on single-name securities, loans, and issuers are the jurisdiction of the SEC and are not yet subject to mandatory reporting requirements.

The event window is the six-month period on either side of the start of mandatory reporting in the United States on 31 December 2012 (i.e., July 2012–June 2013). Each period is also compared to a control period, which is the equivalent period from 12 months earlier (i.e., July 2011–June 2012).The report looks at four metrics: gross notional outstanding, net notional outstanding, traded notional, and total number of contracts outstanding over the event window. The gross notional, net notional, and total contracts data is meant to reflect market risk exposure while traded notional is used as a measure of market activity.

The findings suggest that neither market activity nor market exposure changed substantially due to the introduction of post-trade transparency. Specifically, trading activity around the event date is similar to levels seen during the control periods (12 months prior to the event date). The report does show that the levels of gross notional, net notional, and total contracts outstanding exhibit large drops just before the event date, which seems to imply a negative impact of the transparency rules. However, the authors note that similar declines are observed for CDS not subject to mandatory post-trade reporting and that this is likely because of a common 20 December maturity date, which almost exactly coincides with the introduction of mandatory reporting.

IOSCO concludes that there is no evidence that mandatory post-trade transparency rules had a significant effect on market risk exposure or market activity in index CDS products. They go on to recommend that greater post-trade transparency in the CDS market is desirable and encourages other jurisdictions to implement these as quickly as is practicable.

CFA Institute is in most instances supportive of greater transparency in financial markets, including but not limited to securities markets. We believe and empirical analysis broadly supports that increased transparency benefits market quality for investors. This IOSCO report seems to confirm that this is true also of CDS markets.

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Image Credit: iStockphoto.com/Jeff_Hu