Wednesday, April 25, 2007

CDS's and Liquidity Generation

The latest ISDA survey puts the total amount of Credit Default Swaps (CDS) outstanding at $US 34.5 trillion, up from next to nothing just six years ago. Even as recently as two years ago there were "just" $US 8.4 trillion. Does this mean anything for the "real" economy, beyond the regular incantations about "spreading risk around", "lower risk premia", "reduced volatility", etc, etc ? Yes, it does.

(A) First, we must remember that "liquidity" is just another name for debt: liquidity is created via the assumption of debt and its price is the interest rate charged to borrow it.

(B) Second, we should note that CDS's are streams of regular cash flows: an upfront payment plus regular, fixed payments for the duration of the contract. This is the reason they are sometimes called "counterfeit bonds".

(C) Thirdly, their issuance is not limited by ANY sort of regulation, barrier or corporate requirement for debt financing. As long as the "market" buys them, issuers keep selling them.

Put A, B and C together and what do you get? Artificial debt creation (i.e. liquidity), regardless of the need by corporations, individuals or governments to borrow for factories, homes or teacher salaries. This type of liquidity creation is also very difficult for central banks to contain with monetary tools: it is not directly impacted by higher or lower interest rates, but by the perception of default risk.

Naturally, $34.5 trillion is the notional amount - the amount due if default occurs, not the market value of the contracts. To approximate how much "liquidity" is created by the CDS's, we need to know their current market value. ISDA does not collect such data, but the Bank for International Settlements does, though its data only goes to June 2006. At that time market value was 1.44% of notional; applying the same percentage to the latest data ($34.5 trillion) we come up with $497 billion, i.e. a half-trillion dollars of "liquidity" is sloshing around that was not created to fund anything other than "creative finance" ...and it is growing 100% every year!

Now, add this dirt-cheap money to the yen "carry" and we may currently have a pool of up to $1.5 trillion in loose, hot cash whizzing around, looking for "investments". I think it goes quite a ways in explaining global market levitation, no?


  1. Hellasious -

    Will increased volatility dry up the CDS and yen carry trade? How quickly? Basically, when will this market levitation end?

    Jason B

  2. Through CDS's, debt and equity markets are now organically connected, as never before. I don't mean only the creation of loose cash for speculation, but the way the CDS market looks at the equity market for confirmation all is well - and vice versa.

    We have thus created a weird type of perpetual, self-congratulatory club that feeds on itself - until it stops, of course.

    When will it stop? When confidence in the "real" economy falters.

  3. notional amount of CDS is over-hyped from those without proper knowledge of this market.

    the "liquidity" in this market merely allows efficient transfer of risk, hopefully to those able to bear those risks (although I'm sure plenty of counterparty's are not in that position!). it doesn't exactly mean debt creation. if the SP500 had 2bn contracts traded daily instead of 1bn (i don't know what the exact numbers are), you wouldn't say that companies can issue equity any cheaper? in the same way, it is the wrong argument for credit derivatives.

    and as for the market value of CDS can it be anything other than zero net-net? each trade is a contract between 2 counterparties (c/p), and so one c/p will be down the same amount that the other is up.

    the growth in CDS is the most over-hyped point from the conspiracy theorists. and trust me, I have been a CDS trader since the market was in its infancy in the 90's, AND i am incredibly bearish on global liquidity/asset values. think you should be looking elsewhere for negatives though.