Amid the growing trading volumes in the credit-default swaps (CDS) market, Wells Fargo & Company (WFC – Analyst Report) plans to boost its trading in the derivative, according to a Bloomberg report.
CDS is a derivative contract that allows an investor to place a bet on whether a company or country will default on its debt within a fixed time period. Basically, it serves as protection against the credit risk stemming from holding the debt instrument.
Citing people familiar with the matter, the report stated that Wells Fargo is likely to trade CDS linked to individual companies in the next quarter. The California-based banking giant intends to trade single-name credit swaps that are backed by a central clearinghouse, which would reduce its transaction costs.
The Securities and Exchange Commission (SEC) has not yet mandated single-name credit swaps to comply with the trading and clearing requirements, which would reduce their liquidity. Market participants believe that central clearing would aid in revival of the product.
Prior to the financial crisis, the credit swaps business grew rapidly as it generated huge profits to several major global banks. However, experts believe that uncontrolled growth of this risky business is one of the reasons behind the 2008 financial crisis.
The collapse of Lehman Brothers Holdings Inc. and the government rescue of American International Group, which had sold swaps agreeing to pay investors for soured mortgages, had changed the scenario for CDS trading. The Dodd-Frank financial overhaul in 2010 made swap trading costlier for banks. Notably, in 2014, German banking giant Deutsche Bank AG (DB – Analyst Report) exited from most of its trading in CDS.
Previously, CDS trading were privately negotiated between parties, which benefited banks as they controlled access to the market and derived huge gains from the contracts. However, per the latest rules of Dodd-Frank, most index swaps require to be traded on regulated platforms, which would aid in greater transparency. Also, such trades need to be processed by clearinghouses that charge fees for providing guarantee of the trades.
While tighter regulations and a weak trading scenario led to the gradual fading of the credit-CDS trade, the current trends are suggesting a reversal mode. The market volatility in recent times has reinforced attraction for CDS among investors. Amid the selling off in stock markets and plunge in junk bond prices, investors are seeking protection against their losses.
Last month a release by the Financial Times noted that in January a record $15.7 billion in gross notional outstanding positions of single name CDS was cleared by investors, citing data of the one of the biggest operators of global exchanges and clearing houses, Intercontinental Exchange (ICE). ICE had stated that new business contributed to most of the volume, in contrast to investors pushing longstanding positions through the clearing house for the first time.
Further, in efforts to boost trading in the product, last December, a group of over 24 investment firms, including BlackRock, Inc. (BLK – Analyst Report), Blue Mountain, Citadel, and Apollo Global Management, LLC (APO – Snapshot Report), decided to settle their own CDS trades linked to individual companies and countries through clearinghouses.
According to the Depository Trust & Clearing Corporation, the current outstanding gross notional for all single name CDS is around $6.8 trillion compared with $14.8 trillion at the end of 2008. Though the figure reflects a substantial decline, a gradual revival seems to be lurking around.
While Wells Fargo should benefit from its potential move, this also may induce other banks to take similar efforts.
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