OTC Derivatives Reform (For quite a while, the exchanges have been clamoring to get into the fairly exclusive club the dealers (the bulge-bracket globally active banks) have in the credit default swaps market. Dodd-Frank, in Title VII mandates the use of swap execution facilities (SEFs) and has given the exchanges the opening they sought.
So what is arguably the first SEF-tradable CDS product by an exchange – the Chicago Board Options Exchange has a contract definition that is brilliantly simple and yet the exchange has managed to shoot itself in the foot.
Very recently the CBOE launched a credit event binary option (CEBO). The CBOE launched the anagrammatic CEBO. The contract has a few brilliant simplifications:
a) Obviate the mystery with the recovery rate and the auction process. The CEBO sets a zero recovery rate. If one is taking a pure speculative view on the credit, then one can do just that without having to implicitly take a position on the recovery rate. If you want to bet on the recovery rate, there is a market just for that – recovery swaps. So just like CDS, componentized the credit risk from within a bond, the recovery swap does the same thing for a CDS.
b) The quotation method is blindingly simple. Just a percent upfront that represents the likelihood of default before the maturity date. Currently CDS can be traded in upfronts as well, though that is reserved for the most risky names. Other than upfronts, the CDS contract can be traded with a running spread with a coupon (which can vary too) or without a coupon (for the highest quality names). This Tower of Babel is replaced by the Esperanto of upfront. What one-time, percentage premium do you wish to pay/receive for protection? Like a lump sum insurance contract. Very simple to understand and compare and contrast.
c) No ISDAs. And no margins for people buying protection. Reducing legal and other operational overheads for the traders.
d) One lump sum premium payment as opposed to accrued interest and quarterly payments on IMM dates and all that jazz for the CDS product. After all, there is nothing swap-like about a CDS. The only reason it was disguised as a swap was to not be under the jurisdiction of the state insurance commissioners. Inspector Jacques Clouseau’s disguises are more convincing!
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5 Comments to "Joining the VIPs, With a Hitch":
tripledtrader
09 May 2011
Interesting point on the spread. I agree, an MPV of a percent makes the option unattractive to short-term speculators, but it does make it attractive to market makers. Maybe this is an attempt to get a market started in these products, and once you have some liquidity, you could then lower the MPV? Like you said, I'd back up the truck on that spread.
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tripledtrader
09 May 2011
but of course if nobody is willing to pay the spread, then market making is useless. You make a good point.
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Bill Hodgson
10 May 2011
How much work did CBOE do with market makers to establish the viability of the product before launch? Odd decision on the variation increment. Bill
kkhetan
10 May 2011
True tripled, Bill. Separately, CBOE confirmed the min price increment. Some otherwise great ideas but ...
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mjdhond
16 May 2011
Interesting read, even for relative lay person. Any idea about the kind of volume CEBOs are attracting?
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