ISDA, the organization whose lawyers provide the contract templates, term definitions and general leadership underpinning the OTC derivatives markets, has just ended its annual pow-wow in Chicago. To mark the occasion it released some data showing the overall health — or lack thereof — of the $3 trillion market. The Financial Times has this eye-opener:
Monthly volumes for credit derivatives fell to an average of 9,098 from 11,357 in 2010 according to the survey of 60 ISDA members. Before the financial crisis, credit derivatives were one of the fastest growing sectors of the over-the-counter market.
This represents a year-over-year drop of about 20%. Credit default swaps (CDS) were not the only laggards: commodity derivatives fell by 24% and currency options were down by 16% from 2010 to 2011.
ISDA seems to be grasping at straws when it comes to explaining why last year’s volumes wilted. It mentioned changes in the population that it surveys and guesses that overstatement from the prior year may have caused the dramatic swing. Could there be other explanations?
As you probably remember, the second half of last year marked the return of great uncertainty around the crisis in Europe. As banks became more nervous about the risk exposure of their peers, they may have demanded more and better collateral in order to participate in the derivatives trades. This may have had a dampening effect on the general deal flow.
But the fall in credit default swaps still surprises, even in the face of this credible explanation. After all, CDS has been one of the standard ways to either hedge a real exposure or to place a bet that a firm (or a country) will get into trouble. So in an environment of increasing fear, one would rather expect CDS volumes to go up, not down.
Here’s another plausible explanation that would certainly not be welcomed by ISDA: the saga surrounding the Greek default may have caused CDS to lose its general credibility as an effective edge.
After months of speculation the Greek government finally restructured its debt in March. Right on cue we saw S&P’s declaration on Wednesday that the country is no longer in selective default. It may be done and dusted now but there was certainly a point, starting in October of last year and lasting right up until March, where there were huge questions as to whether the CDS would provide any benefit to those who had bought it as protection in just such a scenario. Back then many — including the Finance Addict — wondered whether CDS was being dealt a mortal wound. Why would anyone pay for credit protection when they might still be left unprotected?
There’s no real way to prove a linkage between the two facts, but one can’t help but wonder if the decreased trade volume was a sign of CDS buyers going on strike.