Abstract
While CDS Indices have grown in popularity during then last ten years, there are many structural problems inherent in the associated index calculation methodologies, which create substantial tracking errors. As of 2018, the global CDS market covered notional amounts that exceeded US$50 trillion.
CDS indices are widely used in valuation and risk management around the world; for example, during the Global Financial Crisis (2007–2010) the ABX family of CDS indices and the Markit CDX CDS indices (http://www.markit.com/en/products/data/indices/credit-and-loan-indices/cdx/cdx.page) were used to value a wide range of assets such as MBS and corporate bonds. This chapter explains why CDS Indices are inaccurate and, thus, can cause and/or amplify financial instability and systemic risk.
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Notes
- 1.
See Bingham McCutchen (October 8, 2008). Proposals for Regulation of the CDS Market: The New York State Insurance Department Weighs In. http://www.bingham.com/Media.aspx?MediaId=7591
See Chadbourne & Parke (October 2008). Credit Default Swaps Under Siege. Available at: http://www.chadbourne.com/clientalerts/2008/creditdefaultswaps/
See Mayer Brown (2008). Revisited: Credit Default Swaps—Are They Contracts of Insurance? http://www.mayerbrown.com/publications/article.asp?id=5694&nid=6
- 2.
S&P Credit Default Swap US Indices states in part:
“The following three indices are included in the S&P CDS U.S index suite:
S&P CDS U.S. Investment Grade Index has a 5¼ year maturity at inception and is comprised of 100 equally weighted (1%) reference entities, which include corporate issuers with public debt or issuer ratings of at least BBB-, BBB-, and Baa3 assigned by two of the three rating agencies: Standard & Poor’s, Fitch, and Moody’s, respectively.
S&P CDS U.S. High-Yield Index has a 5¼ year maturity at inception and is comprised of 80 equally weighted (1.25%) reference entities, including corporate issuers with public debt or issuer ratings below BBB-, BBB-, and Baa3 assigned by two of the three rating agencies: Standard & Poor’s, Fitch, and Moody’s, respectively.
S&P 100 CDS Index is the premier index that seeks to track the performance of the reference entities of the S&P 100 Index. The Index has a 5¼ year maturity at inception and includes the constituents in the S&P 100 Index that have sufficient liquidity in the five-year CDS market. Reference entities are weighted based upon their weighting in the S&P 100…
Index levels are published daily for three calculation types of each of the S&P CDS Indices: base, event inclusive (patent pending), and rolling calculations:
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Base. Reference entities are withdrawn from the index upon a credit event.
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Event Inclusive (patent pending). When a credit event has occurred reference entities remain in the index. These indices are calculated perpetually.
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Rolling. While the other types of CDS indices have specific tenors or maturities and issue new “on the run” indices every six months, this calculation tracks the performance of the event inclusive indices over time. This unique return calculation gives investors a continuous return perspective on the index series over a long-term investment horizon. Software from SuperDerivatives® has been chosen to calculate the Indices.
Complete details of the methodology employed by S&P Indices, including the criteria for index additions and removals, policy statements, and research papers are available on the Web site at www.fixedincomeindices.standardandpoors.com…”
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- 3.
See: Fitch Ratings (September 2006). Global Credit Derivatives Survey: Indices Dominate Growth As Banks’ Risk Position Shifts. See: Fitch Ratings (July 2007). CDx Survey—Market Volumes Continue Growing While New Concerns Emerge. See: European Central Bank (December 2008). Financial Stability Review, Frankfurt.
- 4.
See “Goldman Draws Ire for Advising Default Swaps Against New Jersey” (December 10, 2009) (http://www.bondsonline.com/News_Releases/news12100803.php) which states in part: “Goldman Sachs Group, Inc., one of the top five U.S. municipal bond underwriters, is angering politicians and public-finance officials in New Jersey, Wisconsin, California and Florida by recommending that investors purchase credit-default swaps to bet against the debt of eleven US states. In the three months since the New York-based securities firm recommended “shorting municipal credit,” the value of the Markit MCDX index of the derivatives’ price more than tripled, to as high as 278.33 basis points from 87.75. A basis point on a credit-default swap protecting $10 million of debt for five years is equivalent to $1,000 annually. Bets against public debt, once unheard of on bonds considered safe enough for retirees, have soared as the National Conference of State Legislatures projects recession-fueled budget crises will cause $97 billion of shortfalls nationwide over the next 18–24 months. It’s “disturbing” to advise investors to bet against the financial health of a state whose bonds Goldman helps sell, Assemblyman Gary S. Schaer, a Democrat who chairs the Financial Institutions and Insurance Committee, said last week in a letter to Chief Executive Officer Lloyd C. Blankfein. “New Jersey needs to maximize its presence in the credit markets, not to see its presence undermined.” Schaer wrote…”
- 5.
See Zamansky, J. (July 22, 2018). Recent Blackstone Deal Confirms That The Market Is Rigged. https://seekingalpha.com/article/4188956-recent-blackstone-deal-confirms-market-rigged. This article stated in part:
… A recent, questionable deal by the Wall Street behemoth, Blackstone has shaken investor confidence in the markets. For months now, the Wall Street Journal has been reporting on a shady deal between Blackstone and Hovnanian Enterprises. One of the largest asset managers in the world, Blackstone offered Hovnanian a low-cost loan and “persuaded the builder to miss a small interest payment in exchange, which would trigger payouts on $333 million in Blackstone’s credit insurance contracts and yield the firm tens of millions of dollars, depending on market factors,” according to one article. “The insurance contracts Blackstone took out, known as credit-default swaps, typically pay out when a company defaults, usually reflecting dire financial straits,” the Journal reported. “But Hovnanian was healthy enough to pay its debts, so a default would be opportunistic.” Such financial manipulation is why some investors remain fearful of the stock market, despite its historic 10-year bull run. Who can investors trust when Wall Street fosters such clearly unethical behavior? Solus Alternative Management, the fund which stood to take a loss if derivative contracts held by Blackstone were tripped, sued to put a hold on the deal. A judge in January ruled in favor of Blackstone and allowed the transaction to go through. Banks, hedge funds and the International Swaps and Derivatives Association Industry Group also voiced concern about Blackstone’s strategy, according to the Journal report. Even the regulators got involved. …
- 6.
See Matthew, J. (Sept. 5, 2014). Credit Default Swaps: US Judge Invites Investors to Sue twelve Major Banks for CDS Rigging. https://www.ibtimes.co.uk/investors-could-pursue-lawsuit-against-major-banks-over-credit-default-swap-rigging-1464095. The article states in part: “A US judge said that twelve major banks have violated antitrust laws by working together to limit competition in the credit default swaps (CDS) market, and investors may pursue a lawsuit against them. US District Judge Denise Cote in Manhattan said investors may go ahead with claims that the defendants violated the Sherman Act, causing them to pay unfair prices on CDS trades, used to hedge against credit default risk. The banks involved in the case are Bank of America Corp, Barclays Plc, BNP Paribas SA, Citigroup Inc., Credit Suisse Group AG, Deutsche Bank AG, Goldman Sachs Group Inc., HSBC Holdings Plc, JPMorgan Chase & Co., Morgan Stanley, Royal Bank of Scotland Group Plc and UBS AG. Allegations that these banks conspired to block other entrants in the CDS market and artificially inflated prices for trading in the instruments, were consolidated into lawsuits in 2013 by a group of investors, including public pension funds, which traded Credit Default Swaps with the banks from 2008 to 2013. Cote dismissed claims that the pricing of the swaps were the result of coincidence: ‘The complaint provides a chronology of behavior that would probably not result from chance, coincidence, independent responses to common stimuli, or mere interdependence,’ she said. The International Swaps and Derivatives Association and Markit Ltd., which provide credit derivative pricing services, are also named defendants in the lawsuit.”
See Burne, K. (Oct. 1, 2015). Banks Finalize $1.86 Billion Credit-Swaps Settlement—Suit claimed banks conspired to prevent competition. Wall Street Journal. https://www.wsj.com/articles/wall-street-banks-in-credit-swaps-settlement-1443708335
See: In re: Credit Default Swaps Antitrust Litigation (U.S. District Court for the Southern District of New York, No. 13-md-02476) (USA lawsuit about manipulation of the Credit Default Swaps market by banks).
- 7.
See Rennison, J. (September 28, 2015). Investor lawsuits pile up claiming US Treasury market is rigged. http://www.ft.com/cms/s/0/43f0b014-6218-11e5-9846-de406ccb37f2.html. This article stated in part: “Investors have filed a flurry of court cases claiming banks and brokers have been rigging the Treasury bond market and increasing the cost of selling debt for the US government. Twenty-three related cases have been filed, alleging the primary dealers that underwrite the US government’s debt colluded to manipulate the price of US Treasuries to their benefit. US Treasury securities are sold through an auction process in which banks and brokers listed as “primary dealers” place bids for the number of bonds they wish to buy and at what price. Investors can use primary dealers to buy at the auction or purchase them directly.”
See Dugan, K. (June 9, 2015). Justice Department probes banks for rigging Treasury market. http://www.marketwatch.com/story/justice-department-probes-banks-for-rigging-treasury-market-2015-06-09. The article stated in part: “The Justice Department is looking into possible fraudulent manipulation of the $12.5 trillion Treasurys market, The Post has learned. Government lawyers are said to be in the early stages of a probe and have reached out in recent months to at least three of the 22 financial institutions that act as primary government debt dealers to request information, said a person close to one of the banks who was briefed on the matter. The focus of the probe is on Treasury auctions, a secretive process when interest rates are set for the offerings, the person said. No single bank has become the focus of the probe, it is believed, and no bank has been accused of any wrongdoing at this time. There is no guarantee that the requests for information will turn up wrongdoing.”
See Moyer, L. (Nov. 7, 2006). Fed To Banks: Halt Bond Fraud. http://www.forbes.com/forbes/welcome/. The article stated in part: “The Fed wants banks to stop fraud in the U.S government bond market before regulators have to step in. Regulators and members of Wall Street’s biggest bond-trading operations are discussing ways to strengthen the integrity of the U.S. Treasury market amid a probe of possible market manipulation.”
- 8.
See Stempel, J. (May 18, 2016). Five banks sued in U.S. for rigging $9 trillion agency bond market. https://www.reuters.com/article/us-banks-rigging-lawsuit-idUSKCN0Y932L. This article states in part: “Five major banks and four traders were sued on Wednesday in a private U.S. lawsuit claiming they conspired to rig prices worldwide in a more than $9 trillion market for bonds issued by government-linked organizations and agencies. Bank of America Corp (BAC.N), Credit Agricole SA (CAGR.PA), Credit Suisse Group AG (CSGN.S), Deutsche Bank AG (DBKGn.DE) and Nomura Holdings Inc. (8604.T) were accused of secretly agreeing to widen the “bid–ask” spreads they quoted customers of supranational, sub-sovereign and agency (SSA) bonds. The lawsuit filed in Manhattan federal court by the Boston Retirement System said the collusion dates to at least 2005, was conducted through chat rooms and instant messaging, and caused investors to overpay for bonds they bought or accept low prices for bonds they sold. ‘Only through collusion could a dealer quote a wider spread than market conditions otherwise dictate without losing market share and profits,’ the complaint said. ‘Defendants reaped millions of dollar(s) in profits at the expense of plaintiff and members of the class as result of their misconduct.’ The proposed class-action lawsuit seeks triple damages and follows probes by U.S. and European Union antitrust regulators into possible SSA bond price rigging. Those probes are also examining the London-based defendant traders Hiren Gudka of Bank of America, Bhardeep Singh Heer of Nomura, Amandeep Singh Manku of Credit Agricole and Shailen Pau of Credit Suisse, Thomson Reuters’ IFR service reported in January.”
See Boston Retirement System vs. Bank of America NA et al. (U.S. District Court, Southern District of New York, No. 16–03711) (USA lawsuit about manipulation of the agency bond market by banks).
- 9.
See (EU) Parliament & Council Regulation 236/2012, Short Selling and Certain Aspects of Credit Default Swaps, 2012 O.J. (L 86) 10–14 (EU).
- 10.
See Smith, R. (July 24, 2017). “Credit Default Swaps: A $10 Trillion Market That Leaves Few Happy – Owners Of Contracts Designed To Insure Against Default Frequently Find Themselves Stymied”. Financial Times (UK). https://www.ft.com/content/10af64da-7075-11e7-93ff-99f383b09ff9
See White, C. (Aug. 15, 2016). The Rise And Fall Of The Hottest Financial Product In The World. http://www.businessinsider.com/rise-and-fall-of-cds-market?IR=T. This article states in part:
“Perhaps the most fascinating artifact of the CDS market will be the lasting impression it has made on the leadership structure of credit desks at major investment banks. During its heyday, CDS was such a lucrative product for market makers, that other debt products were practically abandoned. One such major institution even prided itself on being ‘90/10’ CDS to cash in terms of their market making activity. The traders and sales people who made unprecedented amounts of money in the CDS market were gradually promoted to positions of leadership based on their outstanding performance. By 2007, the managing directors and desk heads at most major investment banks had built their careers off the back of CDS mania. As the aftermath of the 2008 credit crisis began to reshape the financial market system, CDS lost its position as the dominant product, yet the CDS focused leadership at many major investment banks has remained in place.”
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Nwogugu, M.I.C. (2018). A Critique of Credit Default Swaps (CDS) Indices. In: Indices, Index Funds And ETFs. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-44701-2_3
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