Credit derivatives popular but facing liquidity challenge: Fitch

The market for single-name credit derivatives has grown in leaps and bounds in recent years, but at the same time has shown volatile performance with respect to liquidity, notes a new report by Fitch Ratings. By the end of 2003, the total credit derivatives (CDx) market had reached almost US$3 trillion in gross notional positions, with single-names credit default swaps (CDS) accounting for US$1.9 trillion, a 100% increase over the year prior. Fitch says.
In “CDS Liquidity Hangs in the Balance”, the rater says
notes that there is anecdotal evidence of a corresponding increase in liquidity for the CDS market as a whole, but when trading volume and availability of a clearing price for distressed names, liquidity was varied at best amongst names.
The absolute number of names quoted in the CDS market has grown between the start of 2002 and the third quarter of 2004. “Growth accelerated in 2004, coinciding with the successful launch of the traded indices, an active market for synthetic collateralized debt obligations (CDOs), increased interest in high yield CDS names, and the growing use of CDS as a trading instrument for hedge funds and the inter-dealer community,” the study notes.
Over the same study period, bid-offer spreads declined significantly concurrent with improved credit fundamentals since 2002 and growth in the frequency of available quotes per name.
Despite this growth, absolute trading volumes have grown at a lesser rate. And the market seems to be hampered by the structured imbalance linked to banks’ use of CDS as a hedging tool. “It will be interesting to see over time whether these imbalances are ameliorated as more participants enter the market, and whether the market can offer true two-way liquidity during the next credit downturn or market disruption,” the study concludes.