Credit derivatives: crunched or cultivated?

As market participants adapt to the end of quantitative easing, the loss of effective 0% interest rates, the need to use hedging instruments returns. But will the market ever return to its pre-crash state?

What impact has quantitative easing had on credit derivatives?

The main use of credit derivatives, in recent years at least, has been to hedge against losses from investments in? corporate debt. During a recession, one might expect credit default swaps (CDSs) to be in higher demand as more companies are at greater risk of default, necessitating hedging by investors. Similarly, a more volatile credit market offers opportunities to profit using derivatives.

However, quantitative easing (QE) in the US and other countries has seen the authorities buying up bonds in spades and reducing the cost of debt. This means there is much less chance of large debt-issuing companies defaulting. The result is that there is little incentive to incur the cost of hedging through use of a derivatives contract.

Back in August 2012, the Markit CDX North America Investment Grade Index saw two significant drops, down 1.5 basis points on 17 August and a further 1.4 basis points on 31 August to a mid-price of 101.5 basis points. The falls were largely attributed to expectations that Federal Reserve chairman Ben Bernanke would announce further quantitative easing in September. Trading volumes in certain single-name CDSs have slowed to a standstill too, confounding price discovery.

So how has this changed?

When Bernanke signalled QE would end in 2014 last month (though he has since backtracked somewhat), most expected increased use of credit derivatives. With less government support for lending leading to higher interest rates, the risk of a corporate bond defaulting increases. This then causes credit market volatility to increase and thus investors will be more likely to hedge that risk or even look to make money out of the market to escape the increased volatility.

There were some early signals that this has happened. On 29 May, CME Group said its Globex platform saw record levels of trading, reaching an all-time record high with 27 million CDS contract traded, while the daily average for Q2 2012 was just 10.6 million. The shift followed suggestions some Fed officials were pushing for quantitative easing to begin tapering off even ahead of Bernanke's timetable.

Will this market return to its pre-crisis levels soon?

This remains to be seen. Before Lehman Brothers collapsed, primary dealers' average daily volume of US Treasuries trading as a percentage of outstanding Treasury debt was around 10-11%, but between 2008 and 2012 this fell to between 4-6%, according to Nasdaq OMX data. As a proxy for US debt market activity overall, this suggests volumes have got a long way to go.

But it would certainly seem there is room for a significant rebound as quantitative easing comes to an end, despite recent Fed has stated it might not taper the support as quickly as it has initially stated. Meanwhile, the Bank of England and the European Central Bank have both made it clear they expect to keep buying bonds and keep interest rates at historic lows for some time to come.

Even when quantitative easing does end, many are forecasting the global economy will be in a depressed state for years as countries, corporates and individuals continue to deleverage. Add to this the increasingly tough regulatory environment for derivatives and it seems unlikely traders will return to credit derivatives with the same fervour they had in the early years of this century.

Against this uncertain macro-economic backdrop, trading in CDSs and other OTC instruments is supposed to be migrating onto new exchange-like trading platforms under the Dodd-Frank Act, although this process has been complicated by delays in rule-setting and the competitive products offered by established exchanges. At the same time, banks - forced to trim their balance sheets by Basel III - are increasingly trading on an agency basis in the fixed-income markets, rather than principle.  No wonder many mid-tier buy-side firms are concerned about the future cost of fixed income investing in general, and CDS spreads in particular.