Credit Default Swaps Makeover

CBOE says its new exchange-traded version offers more hedging flexibility.

Credit default swaps (CDS) were stigmatized for their role in the financial crisis, but a new exchange-traded version may breathe life back into the notion of CDS as a tool that companies can use to analyze and potentially hedge credit risk.

“Anything we can do that sheds more light on corporate liquidity and credit is fabulous,” says Jerry Flum, CEO of CreditRiskMonitor, which provides real-time financial analysis and news.

Both the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange launched credit default products in 2007, just as the financial crisis was beginning to unfold. The products never got off the ground, partly because CDS were named a factor in the global financial meltdown and the collapse of AIG and other financial giants, and partly because the exchange-traded products were difficult to customize to users’ needs.

The CBOE is making another go of it, however. The updated product, launched in March, offers more hedging flexibility than the exchange’s initial try, and is much more straightforward to use than over-the-counter CDS.

The exchange has listed credit-default options (technically known as credit-event binary options, or CEBOs) for 15 companies, including Advanced Micro Devices, AK Steel, and Smithfield Foods, along with financial institutions such as Bank of America and JP Morgan. But it had yet to see any trades as of mid-April.

“We chose names we thought were prominent,” says Dennis O’Callahan, director of research and product development at the CBOE.

O’Callahan says that CEBOs have garnered a relatively high level of interest compared with the product launched back in 2007, with much of that interest coming from hedge funds already familiar with the CDS market. No corporates have identified themselves as users, he says, but if liquidity develops, the options may become a useful tool for companies’ finance executives.

Credit default products, after all, provide the market’s view on a company’s default prospects. During the credit crisis, however, quotes on OTC CDS—provided by Wall Street firms’ trading desks—often didn’t seem to reflect the dire situation of many financial firms whose balances sheets were rapidly eroding.

Quotes on the exchange-traded version (or the lack of them), on the other hand, are readily available on screens. And because the options are traded in increments of $1,000— instead of $5 million or $10 million for CDS—a greater number and broader array of market participants should be able to express their opinions.

Thomas Deas, treasurer at FMC Corp. and president of the National Association of Corporate Treasurers, says companies typically have not used credit-default products to hedge the risk that a customer or critical supplier may default. However, finance departments may review the spreads on relevant swaps to gauge a firm’s credit risk, and then work with their sales and credit departments to determine the necessary profitability to warrant that risk, he says, and credit default options could facilitate that process.

“If these are traded in increments of $1,000 on an exchange, where people can see the price, it could increase the efficiency of the pricing,” Deas says.

Credit default options could also be useful to determine the credit risk of a company whose bonds trade infrequently, since the bond quotes are likely unreliable, Deas says. And they could potentially be used by companies to hedge credit risk arising from a long-term supply arrangement, he adds.

The CBOE has spruced up the credit default options since first launching them in 2007. Besides reducing the trading increment from $100,000 to $1,000, thereby opening up the credit default options to a much broader swath of traders, it lowered their margin requirements to match those required for CDS.

Over-the-counter CDS retain the advantage of allowing a user to customize them to its specific needs—think about the contracts Goldman Sachs designed for Paulson & Co. to bet against specific tranches of mortgage-backed securities. However, the smaller increments on credit default options allow for hedging of much smaller credit exposures, and they should be easier to use.

There’s one initial payment between counterparties for credit default options, compared with quarterly or semiannual premiums for over-the-counter CDS. And the options’ payouts are determined by a single credit event: bankruptcy. CDS may be triggered by one of three credit events, with a committee deciding over the next week or two whether an event has actually occurred. That’s followed by an auction to determine the payment, which may take another 30 or more days.

“We believe there are operational efficiencies to the way we do it, and you get your money faster,” O’Callahan says, adding that he suspects corporate boards are much more likely to approve a treasurer’s use of an exchange-traded product.

Jonathan Epstein, head of credit derivatives products at SuperDerivatives, a provider of OTC derivatives data and modeling, notes that recent initiatives to clear over-the-counter CDS trades have already resulted in more market transparency. Although the CBOE clearly hopes to draw users of credit-default derivatives from the OTC market, Epstein says the greater price transparency of an exchange-traded product should actually benefit the OTC market in CDS.

“We’ve seen a lack of demand for CDS, so hopefully interest in CBOE’s product will bring back interest to the OTC side,” Epstein says.

 

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