The Bank for International Settlements reported that OTC derivative volumes increased to a record $708 trillion, up 18% for the first half of 2011. I have some theories on why:

• Increased volatility in FX and commodities, and the concerns around hedging credit risk with Credit Default Swaps (CDS) drove up volumes.
• Interbank interest rate swap trading activity increased as trading opportunities presented themselves in various basis and yield curve spreads.
• Swap dealers have started to better centralize their swap data across products and desks in preparation for reporting to the Swap Data Repositories (SDRs) under the upcoming Dodd-Frank regulation.

I suspect the last bullet may be the most relevant and that perhaps the prior year’s data were not as accurate as they should have been. Until all Swaps are physically reported to SDRs under Dodd-Frank, it will be hard to believe any number that is reported. And frankly, the gross notional volume report is relatively meaningless unless compared to notional exposure that is being hedged or with the net notional amount. Better yet, some risk number starting with current mark-to-market value would have more meaning. For example, $2.9 trillion notional of CDS on sovereign debt could have a net mark-to-market value of $100 billion or $100 million.

The monumental task of setting up and regulating SDRs to capture this all important Swap data is still in its early stages with many of the related definitional rules still pending. US regulators will have to wait until the G20 also completes its rule writing, and then finally they would have to consolidate reporting from dozens of SDRs around the world in order to get the true number. It may be a few years away, and at that point we can be sure that the number reported will be very different.

Governments and large issuers hate them, regulators wrestle with them and the general public do not have a clue of what they are, but Credit Default Swaps are the cleanest way to hedge credit risk.  They also promote liquidity (ok, and sometimes volatility) into the bond markets as bond holders can buy CDS protection instead of selling bonds in the open market.  But as Greece and other issuers start to test the waters with voluntary bond swaps, where large investors take a significant haircut on the principle value of the bonds in order to stem a default, CDS holders are crying foul.

In a recognized credit default (i.e. inability to pay the interest payment), a CDS holder can deliver the defaulted bonds and receive the principal value of the delivered bonds, leaving the CDS seller with the loss when it goes to sell the delivered bonds, usually cents on the dollar.  Legally, there doesn’t seem to be grounds for triggering a default if bond holders voluntarily agree to take a haircut on the bond.

Certainly hedge funds who have sold short the bonds via the CDS are fuming as they were hoping to have a huge pay day, which certainly would have happened if it were not for the “voluntary” haircut pressure on the banks from the governments.  Longer term investors who are paying for CDS protection, which for European sovereign debt is currently very expensive, may not only suffer the lower price on the bond swap, but also may have paid for insurance that probably would have made them whole in the event of a default.  As an analogy, if home owners insurance only paid out when robbers stole all of your valuables but not half, you probably wouldn’t be willing to pay for that kind of insurance.

We have known for over six months about the dire situation in Greece and the pending domino effect that would be spurred across Europe.  And despite the changes in governments in Greece and Italy, which should have bought some reprieve, we have seen a nasty sell off in most of the Euro debt in the past week.  Clearly, one of the drivers has been that market participants must be seeing that CDS will not protect their credit risk as once thought, so they have no choice but to reduce risk now by selling down their sovereign credit risk with few cash buyers brave enough to buy as they too may see the writing on the wall on the strength of CDS protection.  Could this be the catalyst that will kill the CDS product?  If it is, then we will have lot more to worry about than the health of the CDS market.

Although final rules for Dodd-Frank have a ways to go and Basel III capital requirements are years away, the market is already reacting.  Prices on longer-dated cross currency swaps varied by 60 basis points, between the high and low price, according to one Swap Dealer.  In normal times, the range would be between three and five basis points.

What is driving this?  Swap dealers are beginning to adjust their models to include risk adjusted capital requirements as it becomes clear that higher capital requirements are right around the corner.  This, coupled with volatility in currencies, illiquidity in long-dated cross currency basis swaps and increased bank credit spreads, has caused more than a tenfold increase in costs as many of these factors will be approached differently from bank to bank.

On a related note, another company reported that the turnaround time to get quotes on longer-dated Fx options was taking five minutes or longer, rather than in seconds, as they had been provided in the past.  Swap dealers seem to have less flexibility in using swap credit lines and either need more time to analyze the credit impact or, if close to breeching a credit line, need time to get proper credit approvals. In years past, the head of the Swap desk had some authority to go over a credit line in the event of an emergency.

One could argue that finally banks are simply pricing in the true credit risk to their corporate counterparties now, resulting in different prices on the same instruments.  As the capital requirements for corporate credit risk is higher than for banks and sovereign entities, the bid offer for corporates should generally be wider, all else being equal.

This will be the way of the world post Dodd-Frank as dealers will be steered towards markets where they get the best return on capital, which most likely won’t be from un-cleared trades with non-financial corporate counterparties.