CDS Spreads in European Periphery – Some Technical Issues to Consider

This new IMF working paper is instructive.

Summary: This paper looks at some technical issues when using CDS data, and if these are incorporated, the analysis or regression results are likely to benefit. The paper endorses the use of stochastic recovery in CDS models when estimating probability of default (PD) and suggests that stochastic recovery may be a better harbinger of distress signals than fixed recovery. Similarly, PDs derived from CDS data are risk-neutral and may need to be adjusted when extrapolating to real world balance sheet and empirical data (e.g. estimating banks losses, etc). Another technical issue pertains to regressions trying to explain CDS spreads of sovereigns in peripheral Europe – the model specification should be cognizant of the under-collateralization aspects in the overall OTC derivatives market. One of the biggest drivers of CDS spreads in the region has been the CVA teams of the large banks that hedge their exposure stemming from derivative receivables due to non-posting of collateral by many sovereigns (and related entities).

5 replies on “CDS Spreads in European Periphery – Some Technical Issues to Consider”

From the McKinsey report…”The deleveraging process is in its early stages in most countries. Total debt has actually grown across the world’s ten largest mature economies since the 2008–09 financial crisis, due mainly to rising government debt. Moreover, the ratio of total debt to GDP has declined in only three countries in our sample: the United States, South Korea, and Australia (Exhibit E1).”

Gavyn Davis seems to suggest otherwise, arguing that debt has merely transferred from private to public sector.

The report is dated Jan 2012 …so who is right?

@ Ceterisparibus

Good question! Above my pay grade. If I understand deleveraging, it is just a polite term for reducing debt. What Davies is saying is that there has imply been a transfer from private to public, not a reduction i.e. there is no contradiction.

What puzzles me is the extraordinary figures for total Irish debt in the McKinsey paper; higher than the UK!

I seem to recall tha there was some discussion of this on another thread but no firm conclusion was arrived at.

The shadow banking system based on the evolution of financial instruments since 1970 onward provides perhaps the greatest threat to the global banking system.

The authors, Bilal and Singh, do a good job picking out the risk posed by CDS to the banking system in particular to Europe. CDS is a form of insurance, but if the CDS itself is risky, the systemic dangers to the system itself is clear.

” …residual risk captures the shortfall of
collateral stemming from clients of large banks not posting their share of collateral to their
clients or vice versa. ”

” Earlier research finds that the 10-15 largest players in the OTC derivatives market may have about $1.5 to 2.0 trillion in under-collateralization for derivative receivables and a similar amount of derivative payables (BIS, 2011; Singh, 2010). Such
residual liabilities and assets exist because client’s of large banks, sovereigns (and related
entities), AAA insurers/pension funds, large corporates, multilateral institutions (e.g.,
EBRD), Fannie Freddie, and the “Berkshire Hathaway” types of firms do not post their full
share of collateral. They are viewed by large banks as privileged and (presumably) safe
clients. ”

It wasn’t clear to me the relationship between CDS and OTC. I’ve read elsewhere of the scandal of insertion of CDS into OTC thus hiding CDS, often using AAA rated CDS to give ballast to otherwise dodgy OTC.

Cleaning up global financial markets and removal of risk associated with CDS or OTC is an urgent necessity, moves being currently made in this direction with the establishment of clearing houses are to be welcomed

Bilal and Singh show the tail wagging the dog whereby the demand for hedging is seen as increasing rather than reducing underlying risk.

“Thus the demand for hedging such growing receivables leads to a rise in CDS spreads of the
underlying sovereign that is “out of the money”. Market sources indicate that between 25%-
40% of a large dealers’ receivables that need to be hedged may stem from sovereign (or
related entities) exposures; an equal fraction is from corporate clients
. Thus, addressing the under-collateralization issues is important to understanding the CDS spreads in peripheral Europe. ”

“One of the biggest drivers of CDS spreads in the region has been the CVA teams of the large banks that hedge their exposure stemming from derivative receivables due to non-posting of collateral by many sovereigns (and related entities).”

Collateral is the big buzz word in getting to the bottom in understanding CDS. Deep stress testing of CDS under new regulatory requirements should include the requirement of proof with posting of full collateral for CDS paper. Perhaps this will only happen with a collapse of the system.

For more discussion on the controversial issue of collateral nb here:

and here:

” Counterparty risk is highly skewed towards the buyer of CDS protection While the maximum potential loss to the seller of protection is the contract spread for the rest of the contract duration, the buyer of protection could arguably lose the full notional of the contract (in case of simultaneous defaults by counterparty and the reference credit and zero recovery). Thus, counterparty risk is evidently more of a concern for buyers of protection. ”

Don’t agree as I’ve the view the risk from Europe to the global banking system is larger than the risk from CDS to Europe itself.

Current moves to remove exposure of markets to the above collateral risks and risks related to lack of transparency are:

“In 2008 there was no centralized exchange or clearing house for CDS transactions; they were all done over the counter (OTC). This led to recent calls for the market to open up in terms of transparency and regulation.[65] ………..
The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from concerns over the instruments’ safety after the events of the previous year. According to Deutsche Bank managing director Athanassios Diplas “the industry pushed through 10 years worth of changes in just a few months”. By late 2008 processes had been introduced allowing CDSs that offset each other to be cancelled. Along with termination of contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion.[69]
The Bank for International Settlements estimates that outstanding derivatives total $708 trillion.[70] U.S. and European regulators are developing separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, administered by International Swaps and Derivatives Association (ISDA). Two of the key changes are:
1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face.
2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the payout should be is unclear.
Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York, stated
“A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. … Trading will be much easier….
In the U.S., central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group.
In Europe, CDS Index clearing was launched by ICE’s European subsidiary ICE Clear Europe on July 31. It launched Single Name clearing in Dec 2009. By the end of 2009, it had cleared CDS contracts worth EUR 885 billion reducing the open interest down to EUR 75 billion [71]
By the end of 2009, banks had reclaimed much of their market share; hedge funds had largely retreated from the market after the crises. According to an estimate by the Banque de France, by late 2009 the bank JP Morgan alone now had about 30% of the global CDS market.[49]”

The Shadow banking sector requires deep culling if the global financial system is to survive and another 2008 meltdown avoided.

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