As Deutsche Bank’s share price has swung dramatically throughout the week, traders have also fuelled demand for another type of security: the credit default swaps that offer insurance against a default by the lender.
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So heavily have these been traded that they have posed the biggest post-crisis liquidity test of the wider CDS market.
While Deutsche Bank CDS remain the most liquid securities in the sector, some market players are growing concerned that capital constraints imposed by regulators might impede the ability of market-making banks to keep these securities trading freely.
This pressure, they say, may grow ahead of the upcoming quarter end, because “credit valuation adjustments” — a routine re-evaluation of counterparty derivative risk carried out by banks and trading institutions — can require the purchase of CDS protection.
One major concern is that, without the capacity to buy CDS protection directly, market players will instead look to short sell Deutsche Bank shares, or withdraw collateral from the bank to reduce their credit exposure. This could exacerbate the sell-off in the German lender’s shares, triggering a negative feedback loop that only increases the need for credit protection.
“The menu of instruments by which a counterparty can hedge bank risk has shrunk to the point where it is shorting the stock, or nothing,” said one informed party. “I think the risks of a feedback loop have been known for a long time.”
According to Craig Pirrong — a noted derivatives expert from the University of Houston, and a critic of some post-crisis regulation — overall liquidity in the single- name CDS market has deteriorated markedly since 2008, due to the risk-weighted capital constraints imposed by regulators.
“It’s much more costly for banks to make markets,” he noted. “This is especially true for a name like Deutsche, because of the ‘wrong-way’ risk inherent in a dealer bank’s CDS.”
“Wrong-way” risk emerges when both default risk and credit exposure go up in tandem, creating a situation where profits from a winning trade cannot necessarily be realised because the counterparty who owes the funds is no longer solvent.
Since a bank with a short position in Deutsche credit would have to pay out just when the shorting market is most likely to be under stress, this would impose a higher capital charge — leading to a reluctance to make markets.
Gavan Nolan, an analyst at IHS-Markit took a similar view of the CDS situation. “We have seen liquidity diminish in the last few years and this is mainly because of the capital requirements imposed on banks — there aren’t as many as there used to be and there’s been a big push from the buyside firms to increase liquidity.”
Thus far, however, the market for Deutsche Bank CDS has remained active, with the number of quotes registered in the Markit database increasing, said Mr Nolan. Last week’s figures from the Depository Trust & Clearing Corporation showed that Deutsche Bank swaps were the sixth most heavily traded in their sector, supporting the view liquidity is not a problem yet.
“I don’t think what we’re seeing in the case of Deutsche has anything to do with regulation,” said Mr Nolan. “The CDS are reflecting concerns over Deutsche as a bank, so I don’t think it’s an issue of liquidity,” said Mr Nolan.
On Friday morning, the spread between buying and selling prices for CDS on Deutsche Bank’s subordinated five-year debt had widened by 42 basis points to 510 basis points. Equivalent CDS on senior debt were being quoted with a spread of 241bp.
Other market participants expressed doubt that hedge funds would be inclined to short Deutsche Bank shares or withdraw balances because of CDS liquidity issues.
“All in all, with Deutsche Bank there is no liquidity risk, and no solvency risk, only dilution risk,” said one market participant.