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

Mechanism Selection and Trade Formation on Swap Execution Facilities: Evidence from Index CDS

Commodity Futures Trading Commission Research Papers
By Lynn Riggs, Esen Onur, David Reiffen, and Haoxiang Zhu

This study analyzes the customer choice of trading mechanisms on swap execution facilities (SEFs). In particular, it examines how customers expose their orders to dealers and how dealers respond to customers’ requests.

The study uses message-level data for index credit default swaps (CDS) traded on Bloomberg and Tradeweb SEFs in May 2016. These two venues focus on customer-to-dealer trades and they accounted for about 85% of all SEF trading volumes in the index CDS market in 2016. The analysis focuses on request-for-quote (RFQ) and request-for-streaming (RFS) trading mechanisms. A key difference between these two mechanisms is that the RFS quotes are indicative, while RFQ quotes are generally firm.

The study finds that customers are significantly less likely to choose RFQ if their order has a larger notional size. For those orders where the customers choose RFQ, larger trade size significantly reduces the number of dealers queried.

While dealers’ response rates in RFQs are high on average, they tend to be lower if customers include more dealers in RFQ. Past trading relationships are also important factors for customers’ quote requests and dealers’ responses. Dealers are more likely to respond to customers that account for a larger share of their past trading activity.

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Implications of Financial Market Development for Financial Stability in Emerging Market Economies

Bank for International Settlements
By Philip Wooldridge

This research highlights that financial market development over the past two decades has altered rather than eliminated the vulnerability of emerging market economies (EMEs) to large swings in capital flows and exchange rates.

The Covid-19 crisis showed that market development in EMEs remains incomplete. Portfolio rebalancing by investors led to sharp currency depreciations, which amplified portfolio outflows and declines in EME asset prices. In response to market destabilization, EME central banks introduced bond purchase programs, most of which focused on local currency government bond purchases in secondary markets and were relatively modest in size.

The paper points to two specific areas where further market development could support financial stability, including the development of derivatives markets and a larger base of domestic institutional investors. In many EMEs, derivatives markets are small, while hedging costs are high, making it difficult for borrowers and investors to tailor their currency and other risk exposures to their needs.

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The CDS Market Reaction to Loan Renegotiation Announcements

By Florina Silaghi, Alfredo Martin-Oliver and Ahmed Sewaid

This paper analyzes the credit market’s reaction to loan renegotiation announcements through changes in CDS spreads, and demonstrates a significant market reaction to material loan amendment announcements.

The study is based on a sample of CDS spreads of 176 public US companies that belong either to the CDX investment grade index or the CDX high yield index. The data covers 758 loan renegotiations during the period from 2010 to 2017.

Since renegotiation is usually triggered by new information on market conditions or the credit quality of a borrower, loan renegotiation is informative for market participants, leading to a certification effect. The study shows that CDS spreads tend to decrease in response to loan renegotiation announcements. However, not all amendment types are perceived equally informative by CDS market investors.

The study highlights that significant decreases in CDS spreads were the result of material amendments, such as a change in line of credit amount or tranche amount. Complex renegotiations that involved a large number of amendments implied an increase in CDS spreads. The CDS market reaction was stronger for speculative firms, which are more sensitive to downside risk.

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