ISDA highlights a selection of research papers on derivatives and risk management         

Recent Trends in CDS Markets

Office of the Chief Economist Commodity Futures Trading Commission
By John Coughlan, Richard Haynes, Madison Lau and Bruce Tuckman

The report analyzes trends in index and single-name credit default swap (CDS) markets over the past five years, including a breakdown of transactions by counterparty and product type. The analysis is based on Depository Trust & Clearing Trade Information Warehouse data from August 2014 to July 2019.

The report demonstrates that the reduction in outstanding notional was mainly concentrated in single-name CDS in the bilateral interdealer market. The number of position holders, including dealers and clients for single-name CDS, declined by approximately 15% between 2015 and 2019. The number of counterparties for index CDS declined to around 560 in 2019.

The analysis shows that clearing rates increased for both index and single-name CDS. However, clearing increased at a different pace across participant types. For example, almost all hedge fund index positions were cleared in the middle of 2019, while a non-negligible subset of asset manager index positions remained non-cleared. Clearing rates for single-name CDS were lower across all participant types.

The report also analyzes the behavior of individual participant groups, and notes some differences between the groups. For example, while both banks and insurance companies are net protection sellers of single-name CDS, hedge funds are net protection buyers (based on risk-adjusted netting values). At the same time, hedge funds are net protection sellers of index positions as they often arbitrage price differences between an index and underlying portfolio of single-name CDS. The report notes that netting patterns changed over time and they can be volatile.

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Interdependencies in the Euro Area Derivatives Clearing Network: A Multi-layer Network Approach

European Central Bank Working Paper Series
By Simonetta Rosati and Francesco Vacirca

The study analyzes the level of interconnectedness in the euro-area cleared derivatives market. Using the derivatives transactions data reported to trade repositories under the European Market Infrastructure Regulation, the analysis demonstrates the high degree of interconnectedness within and across the different market segments.

The authors build six networks for each underlying asset class category (equities, credit, interest rates, commodities, foreign exchange (FX) and other). Each node in a network represents a central counterparty (CCP), a clearing member or a client (an entity that needs to use a clearing member to access a CCP). An edge between two nodes exists if there is at least one outstanding cleared transaction between two counterparties.

Based on the dataset that contains all open transactions from the trade reports as of June 30, 2017, the study identities more than 26,000 counterparties, 30 of which are CCPs and 190 are clearing members. The rest are clearing members’ clients. The equity market is the most populated market segment, followed by the interest rate market. FX and the credit derivatives markets have few CCP and clearing members.

The authors conclude that it is essential to continue authorities’ efforts to carry out supervisory led, macro-prudential CCP stress testing, given that each CCP individually does not have and cannot integrate information on interdependencies into its own stress tests.

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The Cost of Clearing Fragmentation

Bank for International Settlements Working Papers
By Evangelos Benos, Wenqian Huang, Albert Menkveld and Michalis Vasios

The paper argues that when the same products are cleared across multiple CCPs, clearing fragmentation gives rise to economically significant price distortions. These distortions reflect dealers’ collateral costs and represent a real cost to market end users.

The paper demonstrates an economically significant price differential between the same US dollar-denominated swap contracts cleared in CME and LCH (the CME-LCH basis). The authors provide an explanation for the CCP basis using a variation of the dynamic inventory management model.

If clients in a particular jurisdiction only access their local CCP, either because they are mandated to do so or because they lack the financial resources to access overseas CCPs, it reduces the netting opportunities for dealers’ overall portfolios. This reduction in netting opportunities increases dealers’ collateral requirements as they need to post margin with each CCP. The dealers may pass these increased costs to their clients.

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