14 November 2013

Deutsche Bank: CDS spreads widen under central clearing obligation

Deutsche Bank's research indicates that with the introduction of the new market infrastructure, investors that use CDS contracts to hedge their exposures may face higher premiums and may need to revise their hedging practices.

Among the agreed reforms that aim to increase transparency by moving derivatives trades to organised platforms (such as exchanges) and imposing mandatory reporting requirements as well as setting minimum capital and margining requirements for OTC trades, systematic control of cross-exposures by placing central clearing counterparties (CCPs) between the trading participants has pivotal importance. Given that CCPs interpose themselves between transacting parties and become the buyer and the seller of the same contract, the move to central clearing is a fundamental shift that significantly changes the existing risk management and collateralisation practices of the OTC environment.

In the meantime, the far-reaching change in market infrastructure with the introduction of CCPs undoubtedly affects the value of derivatives contracts, e.g. by impacting CDS spreads. Nonetheless, the magnitude and even direction of the development of CDS spreads after the introduction of central clearing are not obvious, a priori. On the one hand, market participants and policymakers agree that new risk management and collateralisation practices will increase the cost of derivatives trades. Indeed, the increase in trading costs may be reflected in an increase in CDS spreads, through which the higher costs are passed on to end-users. On the other, it is widely accepted that imbalances in information flows lead to liquidity shortages in financial markets. In this respect, an increase in the liquidity of centrally cleared CDSs could work in the opposite direction and in fact reduce CDS spreads.

To assess the impact of central clearing on CDS spreads, Deutsche Bank uses a sample of single-name US corporate CDS contracts (103 firms) from 10 different sectors that were centrally cleared between January 2009 and June 2013. Academic research has found that a firm’s leverage ratio and the volatility of its share price as well as the short-term risk-free interest rate are the main determinants of credit risk. In order to focus on the net effect of central clearing, Deutsche Bank runs an empirical model that controls for time-specific effects in the data and the three main drivers of credit risk. The results of the analysis are statistically significant and worth highlighting:

• On average, CDS spreads increase by 9 bp as a result of central clearing.
• Among firms whose CDSs are centrally cleared, 48% see an increase in CDS spreads whereas only 25% exhibit a decrease. For 27%, central clearing has no impact on spreads.
• In line with the previous pioneer literature, an increase in a firm’s leverage ratio and its share price volatility also increase CDS spreads. The short-term risk-free interest rate has the opposite effect through its role in the discount factor.

Even though results point towards higher CDS spreads for centrally cleared instruments, the increase in spreads could be even greater once the regulatory rules have been fully implemented. Indeed, Deutsche Bank had to restrict its analysis to a narrow number of companies due to the fact that central CDS clearing, to date, is only available for a limited number of firms that have high credit ratings and relatively stable share prices. Thus, using central clearing for a much larger sample of companies may further boost the magnitude of the increase in CDS spreads.

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