The Conundrum of ChinaChina s’s “CDS” Market · 595.3 548.0 614.7 601.0 647.8 632.6 CDS % OTC 9.7% 7.6% 5.3% 5.0% 4.4% 4.0% Source: BIS New trade volumes at the ma jjgor CDS

The Conundrum of China’s “CDS”China s CDS Market

Henry Haiyun Zhang, Ph.D., FRMDirector, UIBE Financial Markets Institute (FMI)Professor, UIBE School of Banking and Finance (SBF)Co-Director, Beijing Chapter, Gl b l A i ti f Ri k P f i l (GARP)Global Association of Risk Professionals (GARP)[email protected]

March 27, 2014

Chi ' "D f lt S " D f lti A P i ?

Introduction

China's "Default Swaps": Defaulting on A Promise?

China's "Default Swaps": What Went Wrong?China s Default Swaps : What Went Wrong?

Product Redesign: Other Side Effects?Product Redesign: Other Side Effects?

Bond Default: What’s New?

Summaryy

The trillion dollar question:How to awaken China’s “CDS” market?How to awaken China s CDS market?

•In late 2010 China unveiled its onshore credit derivatives market with•In late 2010, China unveiled its onshore credit derivatives market with the launch of two Credit Risk Mitigation (CRM) products: the CRM Agreement (CRMA) and the CRM Warrant (CRMW).•Modeled after Credit Default Swaps (CDS) the CRM products are•Modeled after Credit Default Swaps (CDS) , the CRM products are dubbed “the CDS of China”. •The CRM launch was hailed as a major innovation to help China’s b ki i d t h d dit i th t f t illi fbanking industry hedge credit exposures in the tens of trillions of yuan and were anticipated to replicate the dazzling success of the CDS product in western markets.•Three years after its much celebrated launch, the CRM market remains languid.

•Why did the CRM market fail to thrive?

3 | © 2012 Global Association of Risk Professionals. All rights reserved.

Financial Markets Institute3

The CRM bottleneck: Mainstream studies focus on market and regulatory issuesfocus on market and regulatory issues

Mainstream diagnosis of the causes of the CRM’s plight:Mainstream diagnosis of the causes of the CRM s plight:•CRM protection has yet to win banking regulatory approval for capital relief•There has been a lack of non-bank participantsThere has been a lack of non-bank participants•Current accounting, taxation and legal systems do not adequately accommodate CRM products•Inadequacies in data and models hamper CRM pricing visibilityInadequacies in data and models hamper CRM pricing visibility

Mainstream prescription for jumpstarting the CRM market:•Facilitate regulatory clarification on CRM protection’s capital relief functionfunction•Encourage non-bank financial institutions to participate in the CRM market•Enhance accounting, taxation and legal treatments for CRMg, g•Adjust credit risk analytical models to suit local needs and disseminate relevant knowledge



The CRM bottleneck: Are mainstream studies barking up the wrong tree?barking up the wrong tree?

I argue that the real bottleneck lies in product designI argue that the real bottleneck lies in product design…

“CDS: China-Style Innovation”,New Fortune, October 2010Authors: Haiyun Zhang, Xingyu Jing, Huifeng Pan

“The Conundrum of China’s CDS Product(s)”,Modern Bankers, March 2014Author: Haiyun Zhang




Introduction





Summaryy

International perspectives I (Pre-crisis):The rise of credit derivativesThe rise of credit derivatives

1998 2004 2005 2006 2007 2007 / 19981998 2004 2005 2006 2007 2007 / 1998 (multiples)

Global Credit Derivatives Outstanding ($ bn)

350 6,396 13,908 28,650 57,894 165

Global OTC Derivatives O di ($ b )

80,309 258,628 299,261 418,131 595,341 7Outstanding ($ bn)

CD % OTC 0 4% 2 5% 4 6% 6 9% 9 7% 22CD % OTC 0.4% 2.5% 4.6% 6.9% 9.7% 22

Source: BIS BBA



Source: BIS, BBA

International perspectives II (Post-crisis): Continued growth amid reformsContinued growth amid reforms

2007 2008 2009 2010 2011 2012

Global Credit Default Swap Outstanding ($ Trn) 57.9 41.9 32.7 29.9 28.6 25.1

Global OTC Derivatives Outstanding ($ Trn) 595.3 548.0 614.7 601.0 647.8 632.6

CDS % OTC 9.7% 7.6% 5.3% 5.0% 4.4% 4.0%

Source: BISNew trade volumes at the major CDS dealers were almost twice as high in the first nine months of 2010 as j gin the same period in 2007, according to Markit. Instead, the sharp drop in the volume of outstanding CDS is due to trade compression and the move to central counterparties in the CDS market.

Nicholas Vause, “Counterparty risk and contract volumes in the credit default swap market”, BIS Quarterly Review, December 2010

CDS market risk transaction activity, as measured by notional amount traded, increased 15% in the 2013 period vs. the 2012 period after dipping slightly in the 2012 period vs. the 2011 period. The number of CDS transactions executed increased for the past two consecutive years.

“CDS Market Summary: Market Risk Transaction Activity”, ISDA Research Notes, October 2013



2013

International perspectives III (Post-crisis): New metrics needed for market activityNew metrics needed for market activity

Source:Nicholas Vause, “Counterparty risk and contract volumes in the credit default swap market”, BIS Quarterly Review, December 2010



International perspectives IV (Benefits):Transforming banking paradigmTransforming banking paradigm

China is here The West is here

Traditional Banking Model New Banking ModelTraditional Banking Model

Originate & Hold

New Banking Model

Originate & Distribute

Shadow Banking System

Lending intermediaries Credit Derivatives

Securitization

While the global financial crisis demonstrated the perils of excessive financial innovations

gthat take no deposits

Securitization

While the global financial crisis demonstrated the perils of excessive financial innovations and over-development of the shadow banking system in developed economies, China still suffers from a paucity of robust risk transfer mechanisms to act as shock-absorbers for risks concentrated in the banking system.



g y

International perspectives V (Vitality)：Continual refinementContinual refinement

•CDS trading and hedging•Dealer intermediated •CDS market grew 30 times 2002 07 •CDS standardization facilitated central•CDS trading and hedging gained economy of scale in the new millennium•Conseco (00): Restructuring•National Power (00): Succession

•Dealer‐intermediated credit derivatives transactions & synthetic securitization emerged in the 1990s•Much confusion

•CDS market grew 30 times 2002‐07•Standardization progressed further in mainstream CDS transactions•Standard CDS index market grew rapidly•Correlation trading & CVA trading came to mainstream

•CDS standardization facilitated central clearing & trade compression efforts, intended to reduce counterparty risk•Sub bond losses during bail‐ins of Irish bank Anglo Irish (2010) & Dutch bank SNS Reaal (2013) called for establishingSuccession

•Railtrack PLC (02): Convertible bonds•Argentina (02): Repudiation / Moratorium

Much confusion existed in documentation, definition, and mechanisms

to mainstream•Hedge funds made massive entry•Market growth called for simplification•Financial crisis highlighted perils of counterparty risk, leverage & opacity

SNS Reaal (2013) called for establishing bail‐in as a new credit event•The Greek sovereign debt swap (2012) called for clarification regarding sovereign debt conversion

1999 2003 2009Inception Expansion Tribulation Maturation

2014

ISDA ”1999 Credit Derivatives Definitions”:•Cleared up a number of issues in documentation, definition, and

ISDA ”2003 Credit Derivatives Definitions”:•Clarify deliverable obligations in Restructuring credit event•Clarify succession in Mergers, Spin‐

ISDA “Big Bang” & “Small Bang” :•Refine default determination & settlement mechanisms and standardize look‐back window•Remove Restructuring as

ISDA ”2014 Credit Derivatives Definitions”:•Incorporate new credit event and associated terms for bail‐in•Clarify delivery mechanisms for

mechanisms offs, etc•Include converts as deliverable obligations•Enhance criteria for Repudiation•Enhance default settlement process

standard credit event in North America CDS•Standardize CDS coupon rates & accrual payment procedures•Establish central clearing facility

sovereign debt conversion•Allow for the adoption of standard reference obligation•Address nuances in succession, contingent obligations, etc.



Credit Risk Mitigation products:The CDS of ChinaThe CDS of China

In late 2010, China unveiled its onshore credit derivatives market with the launch of twoIn late 2010, China unveiled its onshore credit derivatives market with the launch of two products: Credit Risk Mitigation Agreement (CRMA) and Credit Risk Mitigation Warrant(CRMW).With respect to Obligations, the CRM products adopted the “Reference Obligations Only” f t d j t d th t d d t b d f t i i t ti l k tfeature and rejected the standard category-based feature in international markets.

CRMA CRMW• Bilateral contracts between two

counterparties similar to CDS contracts

• Reference asset must be either a

• Credit enhancement contracts on publicly traded debt, sold by qualified financial institutions, and freely tradable like securities• Reference asset must be either a

bond or a loan• Each contract can provide protection

only on a specific bond or loan rather

securities• Standard market operating workflow like in

the bond market, complete with application & registration, issuance & only on a specific bond or loan rather

than a class of debt, a feature that differs from standard CDS contracts in international markets

distribution, and trading & settlement, etc. • Each contract can provide protection only

on a specific traded debt



Launching the CRM market:Extensive research and planningExtensive research and planning

On July 6, 2010, NAFMII published a research report “Research on yInnovation and Development of Chinese Credit Derivative Products” , which provided detailed discussions on:•The necessity for and feasibility of launching China’s credit derivatives marketderivatives market• International credit derivative products and markets, historical perspectives and lessons learned•Planning and design in:

Regulatory framework: Master Agreement, self-regulation & other rules

Product structure: Product types & underlying obligations

Market operations: Participant qualification, trading, clearing & settlement

Disclosure and surveillanceStandardization, additional filing items, statistical analysis & database

Risk managementEntry criteria, risk indicators & collateral management

Ancillary mechanismsCredit event determination & auction settlement mechanism



Launching the CRM market:Comprehensive infrastructure preparationsComprehensive infrastructure preparations

信用风险缓释银行间市场银行间市场中国银行间市场信用风险缓释凭证

创设机构名单

银行间市场信用风险缓释工具相关备案事项

公告

银行间市场信用风险缓释工具试点业务指引

中国银行间市场金融衍生品交易主协议

（凭证特别版）及备案表模板

中国银行间市场交易商协会2010年11月4日



中国银行间市场交易商协会2010年

Interbank Market Derivatives Master A t (S i l

Guidelines on the Interbank Market CRM Pil t P

Disclosure Requirements & Filing T l t f

List of Authorized CRMW Issuers

Agreement (Special Edition for Warrants):Including special provisions for CMRW

CRM Pilot Program Templates for Interbank Market CRM Products



Credit hedging in China:A multi trillion dollar potential marketA multi-trillion dollar potential market

Huge and Rapidly Growing Demand for Credit HedgeHuge and Rapidly Growing Demand for Credit Hedge

Source: PBOC, China Bond, UIBE Financial Markets Institute

Compounded Annual Growth Rate (CAGR) over the last decade:•16% for loans outstanding•52% for credit bonds outstanding



The CRM market:Anemic since inceptionAnemic since inception

2010 2011 2012 2013 T l2010 Launch 2011 2012 2013 Total

CRMA: Transaction Count 23 10 13 0 46

CRMA: Transaction Amount (CNY MM) 1,990 610 1,340 0 3,940

CRMW: New Issue Count 8 1 0 0 9CRMW: New Issue Count 8 1 0 0 9

CRMW: New Issue Amount (CNY MM) 690 50 0 0 740

CRMA + CRMW: Count 31 11 13 0 55

CRMA + CRMW: Amount 2 680 660 1 340 0 4 680(CNY MM) 2,680 660 1,340 0 4,680

•Cumulative transaction amount since inception is less than 0.01% of potential market•No new transactions in 2013




Introduction





Summaryy

What went wrong?Questioning mainstream wisdomQuestioning mainstream wisdom

Mainstream Diagnosis Questions AnswerMainstream Diagnosis Questions AnswerCRM protection has yet to win banking regulatory approval for capital relief

Are CRM products truly effective hedges against the credit exposures of target user base?

We will discuss in depthp g p

There has been a lack of non-bank participants

Have transactions to date adequately fulfilled needs for banks to trade with

h h f i k di ifi i ?

Western markets h d li heach other for risk diversification? shed light

Current accounting, taxation and legal systems do not adequately

Have enhancements such as the 2011 clarification by Ministry of Finance on CRM

Nolegal systems do not adequately accommodate CRM products

clarification by Ministry of Finance on CRM accounting treatments helped boost transactions?

Inadequacies in data and models hamper CRM pricing visibility

Have modeling efforts since CRM’s preparation helped boost transactions?

No



The market participant issue:What do the western markets tell us?What do the western markets tell us?

Credit derivatives market share:

Players2000 2003/2004

Protection Buyer (%)

Protection Seller (%)

Protection Buyer (%)

Protection Seller (%)y ( ) ( ) y ( ) ( )

Banks 63 47 51 38

Securities Firms 18 16 16 16

I C iInsurance Companies 7 23 7 20

Corporations 6 3 3 2

Hedge Funds 3 5 16 15

Mutual Funds 1 2 3 4

Pension Funds 1 3 3 4

Government/Export CreditGovernment/Export Credit Agencies 1 1 1 1

Source: British Bankers’ Association Credit Derivatives Report 2000.



British Bankers’ Association Credit Derivatives Report 2003/2004.

The CDS product:An event driven derivative productAn event driven derivative product

P t ti P t ti

Before default and CDS maturity What Types of Credit Events?

Types in 2003 ISDA Definitions:BankruptcyProtection

Buyer Protection

Seller ProtectionPremiums

•Bankruptcy•Failure to pay•Restructuring•Obligation acceleration

If default (credit event) happens b f CDS t it

g•Obligation default•Repudiation / Moratorium

Additional Type in 2014 ISDA Definitions (To go live in September 2014 ):

Protection ProtectionDefault

before CDS maturity (To go live in September 2014 ):•Bail-in

Whose Credit Events?ProtectionBuyer

ProtectionSeller

DefaultPayment

Whose Credit Events?

What to Do Following Credit Events?



The CDS product:Much ado about “Obligations”Much ado about Obligations

•Marks the minimum seniority ofWhich obligation should be cited in the CDS term sheet?

Reference Obligation

•Marks the minimum seniority of deliverable obligations•Often a large & liquid bond issue for CDS•Syndicated secured loan for LCDS

Obligations(“Event Obligations” or “Default Obligations”)

Which obligations can trigger credit event?

Criteria:•Obligation Category•Obligation Characteristics

Which obligations DeliverableCriteria:D li bl Obli ti C tWhich obligations

can be delivered for physical settlement?

DeliverableObligations

•Deliverable Obligation Category•Deliverable Obligation Characteristics



Event Obligation:Category TypesCategory Types

Event Obligation North American Breadth ofEvent ObligationCategory

North American Corporate CDS

Market Standard

Breadth of Category Scope

PaymentPayment

Borrowed Money √Bond or Loan

Bond

Loan

Reference obligations only

Borrowed Money (2003 ISDA Definitions, 2.19 (a) (ii)):y ( , ( ) ( ))Any Obligation (excluding undrawn revolving credit arrangements for which there are no outstanding, unpaid drawings in respect of principal) for the payment or repayment of Borrowed Money



Deliverable Obligations:Types of CharacteristicsTypes of Characteristics

Deliverable Obligations North American Corporate CDSDeliverable Obligations Characteristics

North American Corporate CDS Market Standard

Not Subordinated √

√Specified Currency √

Not Contingent √

Assignable Loan √Assignable Loan √

Consent Required Loan √

Transferable √

Max Maturity 30 Y √

Not Bearer √

Not Domestic IssuanceNot Domestic Issuance

Not Domestic Law

Not Sovereign Lender



The CDS product:Protection covers a category of obligationsProtection covers a category of obligations

Loan A Loan B

The reference entity’sobligations include:

CDS Reference Obligation:Often a large & liquid bond issue

Suppose:

Bond CSenior Unsecured

Senior Secured Senior Secured


Bond ESubordinated

Event Obligations Deliverable ObligationsIn a standard

Loan ASenior Secured

Loan BSenior Secured

g g



Corporate CDS in North America


Bond ESubordinated




The CDS product:The “Reference Obligations Only” selectionThe Reference Obligations Only selection

•Among the Obligations (“Event Obligations”) Categories you can also chooseAmong the Obligations ( Event Obligations ) Categories, you can also choose “Reference Obligations Only”, but this is not the CDS market standard.•CRM’s “Specific Obligation” feature is equivalent to selecting the “Reference Obligations Only” in CDS.

Loan A Loan B

The reference entity’sobligations include:

CDS Reference Obligation:Often a large & liquid bond issue

Suppose:





Bond DSubordinated

In a “Reference Obligation Only” CDS

Event Obligations Deliverable Obligations





Credit Risk Mitigation products:Alterations to international standard CDSAlterations to international standard CDS

In late 2010, China unveiled its onshore credit derivatives market with the launch of twoIn late 2010, China unveiled its onshore credit derivatives market with the launch of two products: Credit Risk Mitigation Agreement (CRMA) and Credit Risk Mitigation Warrant(CRMW).With respect to Obligations, the CRM products adopted the “Reference Obligations Only” f t d j t d th t d d t b d f t i i t ti l k tfeature and rejected the standard category-based feature in international markets.

CRMA CRMW• Bilateral contracts between two

counterparties similar to CDS contracts

• Reference asset must be either a

• Credit enhancement contracts on publicly traded debt, sold by qualified financial institutions, and freely tradable like securities• Reference asset must be either a

bond or a loan• Each contract can provide protection

only on a specific bond or loan rather

securities• Standard market operating workflow like in

the bond market, complete with application & registration, issuance & only on a specific bond or loan rather

than a class of debt, a feature that differs from standard CDS contracts in international markets

distribution, and trading & settlement, etc. • Each contract can provide protection only

on a specific traded debt



Credit hedging in China:The Who What and HowThe Who, What and How

Observations Conclusions•Loan outstanding is currently10 times the size of credit bonds outstanding

•There is significant demand for hedging loans but not bonds

•The bond market had not experienced any actual default until March 2014•Banks are the largest holders of bonds

•Demand for hedging comes mainly from banks

M t l i Chi bil t l d h It ld b diffi lt f th b d•Most loans in China are bilateral and have no market visibility

•It would be difficult for the broad market to embrace those obscure loans as reference obligations

Conclusions:•In China, until recently the product’s usefulness has been limited to helping banks(Who) hedge their loan exposures (What)(Who) hedge their loan exposures (What)•To develop a broad following, credit protection should reference well known bonds (How) rather than obscure bilateral loans



What’s missing in mainstream diagnosis?A hedge is a hedge or is it?A hedge is a hedge, or is it?

Obligor’s Bank Asset Credit Protection





gSenior Obligations To Be Hedged Reference Obligation

Relevant obligations


Bond DSenior Unsecured

Loan AS i S d

Loan BS i S d

Market Standard CDSCovers All Obligations in a Category

China’s CRMCovers Reference Obligation Only

Obligations covered by credit protection

Senior Secured Senior Secured




If default occurs on Loan ABut not on Bond C

Bank is entitled tocredit protection payment

Bank is NOT entitled tocredit protection payment



Regulatory capital:When can credit protection bring relief?When can credit protection bring relief?

•Basel II 162 (Additional operational requirements for credit derivatives)•Basel II, 162 (Additional operational requirements for credit derivatives)•(b): If the credit derivative covers obligations that do not include the underlying obligation, section (g) below governs whether the asset mismatch is permissible•(g): A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (1) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i e the sameunderlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.•(h): A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (1) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clausessame legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.

•Chinese bank capital requirements are the same as the above



Regulatory capital: Interpretation of capital relief criteriaInterpretation of capital relief criteria

Yes

Capital Relief

D th dit No Is the underlyingDoes a default on the underlying obligationYes

Yes

Does the credit protection cover the underlying obligation?

No

Yes

Is the underlying obligation not subordinate to the reference obligation?

underlying obligation cause cross-default or cross-accelerate in the reference bli ti ?

Yes

No

obligation?

No

No Capital Relief



Regulatory capital relief: CRM versus international standard CDSCRM versus international standard CDS

Yes

Capital Relief

D th dit No I th l tDoes a default on the lYesDoes the credit

protection cover the loan to be hedged?

No

Yes

Is the loan not subordinate to the reference bond?

loan cause cross-default or cross-accelerate in the reference bond?

Yes

reference bond?

NoCRM (China)

No Capital Relief

( )

CDS (International Standard)



Protection referencing a bond:Capital relief for offsetting a loan exposure?Capital relief for offsetting a loan exposure?

Obligor’s Bank Asset Credit Protection





gSenior Obligations To Be Hedged Reference Obligation

Relevant obligations



Does the credit protection cover Loan A? Yes No

Market Standard CDSCovers All Obligations in a Category

China’s CRMCovers Reference Obligation Only

cover Loan A?

Will default on Loan Atrigger cross-default or cross acceleration in Bond C?

Nocross-acceleration in Bond C?

Yes NoShould the credit protection be recognized for capital relief against Loan A?



g


Introduction





Summaryy

Specific Obligation feature：Does it have any advantages?Does it have any advantages?

信用风险缓释工具（CRM）参与主体多元化相关问题研究

中国银行间市场交易商协会

中国信用衍生产品创新与发展问题研究中国银行间市场交易商协会中国银行间市场交易商协会

2012年6月

CRM使每笔交易合约都与具体债务对应在交易结构上比国际通行的

中国银行间市场交易商协会2010年7月

虽然指定标的债务在一定程度会影响市场参与者的交易效率但在信对应，在交易结构上比国际通行的

CDS更加简单明了，充分体现了标的债务的‘穿透性’原则。

响市场参与者的交易效率，但在信用事件处理上会更加简单，也更容易判断市场参与者的真实交易意图，有利于市场风险防范有利于市场风险防范。

NAFMII asserted that altering the CDS product’s Obligation feature helps containing risk by improving transparency. In fact, in addition to hedging ineffectiveness, which we have discussed, this alteration is inferior from many perspectives, including risk containment.



Choice of underlying：An appraisal frameworkAn appraisal framework

S ifi Obli i Obli i C ?Specific Obligation or Obligation Category?• Basic considerations: simplicity, transparency, standardization, liquidity• Stakeholder perspectives: hedgers, investors, dealers, regulatorsp p g , , , g• Hedging efficiency: availability, precision, cost efficiency• Willingness to trade: anonymity, flexibility, precision, price discovery, cost

efficiencyefficiency• Market efficiency: price discovery, liquidity, comparability• Regulatory efficiency: simplicity, transparency, standardization, comparability



Choice of underlying：Stakeholder perspectivesStakeholder perspectives

Hedgers Investors Dealers RegulatorsHedgers Investors Dealers Regulators

Activities Hedge debt assets Invest via CDS Intermediate transactions

Supervise the markettransactions market

Needs •Low transaction costs, high liquidity, good anonymity

•Low transaction costs, high liquidity, good anonymity

•High liquidity, good anonymity•Flexibility &

•Sufficienttransaction data to facilitate g y y

•Flexibility & precision in hedging cash debt•Standardized

g y y•Flexibility & precision in hedging CDS & cash debt assets

yprecision in hedging CDS•Standardized, transparent and

systemic surveillance•Standardized, transparent and•Standardized,

transparent, and complete price reference

cash debt assets•Standardized, transparent, and complete price

f



reference



Mainstream transaction structures in international CDS marketsinternational CDS markets

I i t t ti t t i i t ti l CDS k t h CDS• In mainstream transaction structures in international CDS markets, each CDS family protects an entire category of obligations of a given reference entity, with tenors of 1 to 10 years and quarterly rolls for on‐the‐run CDS, constituting a standard CDS spread term structure as pricing benchmarksstandard CDS spread term structure as pricing benchmarks.

• CDS mostly have standard maturity dates and quarterly coupon dates on the 20thday of March, June, September, and December.

• Post‐crisis CDS reforms standardized CDS coupon rates (100 bp & 500 bp in North America, and 25 bp, 100 bp, 500 bp, & 1000 bp in Europe) and look back windows.

• In international markets, credit default swaps are more standardized than other OTC derivative products. This advantage facilitates hedging, settlement, netting and monetization, and improves liquidity and transparency.

• Obligation Category has advantages over Specific Obligation from various perspectives such as economy of scale, standardization, price discovery, willingness to trade, and regulatory efficiency.



The "obligation category" advantage：Economy of scaleEconomy of scale

Specific Obligation Obligation Category

Characteristic Each obligation belongs to a Each CDS family protects an entire g gseparate CDS family, making the CDS market fragmented and illiquid.

y pcategory of obligations, bringing economy of scale and enhancing liquidity.

Consequence



The "obligation category" advantage：StandardizationStandardization


Characteristic A CDS family vanishes with the maturity or prepayment of the

A CDS family persists as long as there are obligations in thematurity or prepayment of the

corresponding obligation, creating a discontinuity, hampering the construction of a standardized rolling

there are obligations in the corresponding category. This fits naturally with a standardized rolling CDS term structure, and market data

CDS term structure, and hindering comparability and standardization in market data. Any new debt issues calls for a separate CDS family.

becomes directly comparable across CDS families and across time.

p y

ConsequenceConsequence



The "obligation category" advantage：Price discoveryPrice discovery


Characteristic A fragmented CDS market Superior size, liquidity,A fragmented CDS market lacks liquidity and comparability, hindering price discovery.

Superior size, liquidity, standardization and comparability in the CDS market facilitates price discovery.p y p y

CConsequence



The "obligation category" advantage：Hedging efficiencyHedging efficiency


Characteristic An obligation can be precisely A CDS protecting an obligation g p yhedged with its corresponding CDS family. However, hedging an obligation with protection referencing a different obligation becomes

p g gcategory does not necessarily offset specific obligation exposure will full precision, but can adequately cover losses Furthermore it facilitates thea different obligation becomes

ineffective. Furthermore, hedging CDS with a matching CDS becomes difficult in a fragmented CDS market.

losses. Furthermore, it facilitates the precise hedging of CDS with CDS. In addition, superior liquidity lowers the cost of hedging.

Consequence



The "obligation category" advantage：Regulatory efficiencyRegulatory efficiency


Characteristic Transparency in trading intention Lower transparency in trading p y gfacilitates regulation, but the fragmentation and lack of comparability in CDS market data hinders data aggregation efforts

p y gmotives complicates regulation, but the CDS market’s connectedness,standardization, and comparability facilitates data analysis and markethinders data aggregation efforts

of regulators.facilitates data analysis and market surveillance for regulators.

Consequence



The "obligation category" advantage：Willingness to tradeWillingness to trade


Characteristic Hedgers would be trapped in a Hedgers of debt assets would g ppdilemma of hedge ineffectiveness and loss of privacy. CDS dealers and investors would fret the inferiority of hedging

gwelcome the privacy & flexibility in their hedging activities. CDS dealers and investors would enjoy superior hedging precisionfret the inferiority of hedging

precision, liquidity and comparability. enjoy superior hedging precision, liquidity and comparability.

Consequence




Introduction





Summaryy

China’s first bond default：A new era for China’s credit sector?A new era for China s credit sector?

Shanghai Chaori in Default on Bond Interest PaymentsSolar-Equipment Maker Becomes China's First Domestic Corporate-Bond Default

By LINGLING WEI, Wall Street JournalUpdated March 6, 2014 11:50 p.m. ET

So far, the Chinese government and state-owned banks have largely kept risky borrowers afloat by providing bailouts or debt extensions, keeping borrowing costs y p g p g glow for companies with high debt.As of the end of June, the most recent period for which such data are available, Chaori had failed to pay 12 banks almost 1.5 billion yuan of loans on time.



Credit new era：Good news for bond CRM?Good news for bond CRM?

•What’s new:What s new:•Bond default risk is now real•Credit protection on bonds now has intrinsic economic substance

•Question mark:Question mark:•How much will this new development benefit the CRM market?

•Food for thought:•To what extent will this new development boost CRM’s usefulnessTo what extent will this new development boost CRM s usefulness in hedging loans?•To what extent will this new development boost CRM’s usefulness to bond investors?to bond investors?



Credit new era：Good for loan hedging with bond CRM?Good for loan hedging with bond CRM?

•Now that bond default is possible will bond CRM effectivelyNow that bond default is possible, will bond CRM effectively hedge loan exposure?

•The answer remains “No”•CRM protects the reference bond only and does not cover the loanCRM protects the reference bond only and does not cover the loan.•Loan default will not automatically trigger a default on the reference bond unless cross-default or cross-acceleration provision is in place

•Now that bond default is possible will bond CRM bring regulatoryNow that bond default is possible, will bond CRM bring regulatory capital relief against a loan exposure to the reference entity?

•The answer remains “No”•CRM protects the reference bond only and does not cover the loanCRM protects the reference bond only and does not cover the loan.•The CRM protection does not quality for regulatory capital relief against the loan exposure unless cross-default or cross-acceleration provision is in placeprovision is in place



Credit new era：Good for CRM usage among bond holders?Good for CRM usage among bond holders?

•Bond default risk is now real, will this increase CRM’s usefulness from a bondBond default risk is now real, will this increase CRM s usefulness from a bond market perspective?

•The answer is “Yes”•CRM protection is effective in hedging the reference bondp g g•Buying CRM protection offers an alternative to selling or shorting a bond•Selling CRM protection offers an alternative to buying a bond•Pricing discrepancy between bond and CRM can give rise to opportunities in b i t dibasis trading

•Will this new development change the disadvantages that come with the “specific obligations” feature in the CRM products?

•The answer is “No”•The answer is No•All the drawbacks of the product alteration remain the same

•What are some key drivers in an investor’s choice of using bonds versus credit derivatives?credit derivatives?

•Transaction costs•Standardization•Other factors



“Alternative trading venue” hypothesis:CDS as standardized bondsCDS as standardized bonds

The rationale is that, while in principle investors can hedge or take a speculative position either using the bond or the CDS market, they will have a preference for using the CDS market when the underlyinghave a preference for using the CDS market when the underlying bond is illiquid, for example because the firm's bonds are fragmented into many separate bond issues. As pointed out by Stulz (2009), “firms have all sorts of different bonds whose prices are affected pby call provisions, covenants, coupon, maturity, liquidity, and so on; in contrast, CDS are like standardized bonds.” According to this argument, the more fragmented and diverse a company's bonds, the more attractive the CDS market becomes as a standardized venue for hedging or speculation.

Oehmke (Columbia University) & Zawadowski (Boston University), “The Anatomy of the CDS Market”, Working Paper, November 2013



Confirming the CDS advantage ：Bond fragmentation boosts CDS marketsBond fragmentation boosts CDS markets

Our analysis, based on novel data on net notional CDS positions and CDS trading volume from the Depository Trust & Clearing Corporation (DTCC) suggests that CDS markets function asCorporation (DTCC), suggests that CDS markets function as “alternative trading venues” for both hedging and speculation in the underlying bond. In particular, net notional CDS positions are larger and CDS markets more likely to emerge when the underlying y g y gbonds of the firm are fragmented into separate issues, suggesting a standardization and liquidity role of the CDS market. This interpretation is supported by the finding that such bond fragmentation is associated with higher trading costs and lower trading volume in the underlying bonds.

Oehmke (Columbia University) & Zawadowski (Boston University), “The Anatomy of the CDS Market”, Working Paper, November 2013



The CRM disadvantage：As fragmented as individual debt issuesAs fragmented as individual debt issues

B d A4B d A3B d A1 B d A2Firm A’s Relevant Bond A4$200 MM

Bond A3$300 MM

Bond A1$200 MM

Bond A2$400 MM

Firm A s RelevantObligations

Market Standard CDS China’s CRM

Credit ProtectionFamilies

Covers All Obligations in a Category

One CDS FamilyCDS A

Covers Reference Obligations Only

Four CRM FamiliesCRM A1, CRM A2, CRM A3, CRM A4

CDS A Covers $1,100 MM Obligations

Bond A1$200 MMCRM A1 Covers

Credit ProtectionCoverage Bond A1

$200 MMBond A2$400 MM

Bond A2$400 MM

Bond A3$300 MM

CRM A2 Covers

CRM A3 CoversBond A3$300 MM

Bond A4$200 MM

$300 MM

Bond A4$200 MMCRM A4 Covers



Credit new era’s impact on CRM：Good news and bad newsGood news and bad news

•What’s changed:What s changed: •Bond default risk is now real

•Good news for CRM:•This change will boost demand for credit derivatives in generalThis change will boost demand for credit derivatives in general

•Bad news for CRM :•This change will not ameliorate the existing drawbacks of CRM’s alteration to the standard CDS structure Some key drawbacks are:alteration to the standard CDS structure. Some key drawbacks are:

•Bond CRM is ineffective in hedging loan exposures•CRM is unable to bring regulatory capital relief to any assets other than the reference obligation unless cross-default or cross-acceleration clause is in place•CRM is as fragmented as bonds and may enjoy no advantage over bonds in terms of liquidity and cost, especially because fragmentation hampers market making activitieshampers market making activities•The CRM fragmentation hampers credit spread term structure construction, price discovery and market visibility




Introduction





Summaryy

Summary

L h d th ith h f f C dit Ri k Miti ti (CRM)• Launched three years ago with much fanfare, Credit Risk Mitigation (CRM) products represent the Chinese version of the CDS product. With a multi‐trillion dollar prospect, the CRM market was hoped to replicate the triumphant rise of the international CDS market Unfortunately the CRM market has beenthe international CDS market. Unfortunately, the CRM market has been languishing since its inception.

• Mainstream studies attribute the CRM market’s plight to regulatory and market constraints but the real problem may lie in product designconstraints, but the real problem may lie in product design.

• To simplify the product, the CRM designers altered a standard product feature in the international CDS market. This alteration was hailed as an innovation. I di h thi lt ti h d d th CRM d t l t th i idiscuss why this alteration has rendered the CRM products useless to their main user‐base and is self‐defeating in many other ways.

• China’s bond market had its first default incident a few days ago, marking the start f hi i d f di d i i i l i l di Cof a new era. This is good news for credit derivatives in general, including CRM.

However, this does not ameliorate the drawbacks of CRM’s faulty alteration to the standard CDS product.



Financial Markets InstituteU i it f I t ti l B i d E iUniversity of International Business and Economics

F d d i 1951 th B iji I tit t f F i T d th U i it f• Founded in 1951 as the Beijing Institute of Foreign Trade, the University of International Business and Economics (UIBE) has grown to become one of China’s best and most internationalized universities in business and finance, benefitting greatly from the explosive growth over the past three decades of China’s marketgreatly from the explosive growth over the past three decades of China s market economy and foreign trade.

• The UIBE Financial Markets Institute was founded in late 2009. The Institute’s founding Director Professor Haiyun Zhang is also a Co Director of the Beijingfounding Director, Professor Haiyun Zhang, is also a Co‐Director of the Beijing Chapter of Global Association of Risk Professionals (GARP). Professor Zhang brings rich industry experience, having worked in trading, structuring, risk management and quantitative analysis at global financial firms such as Merrillmanagement and quantitative analysis at global financial firms such as Merrill Lynch, TD Bank, and Bank of America. The Financial Markets Institute aims to conduct applied research in financial markets, provide actionable insights to financial industry players foster collaboration with financial institutions andfinancial industry players, foster collaboration with financial institutions, and promote exchanges among professionals in the financial industry and the academia.



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Documents

The Conundrum of ChinaChina s’s “CDS” Market · 595.3 548.0 614.7 601.0 647.8 632.6 CDS % OTC 9.7% 7.6% 5.3% 5.0% 4.4% 4.0% Source: BIS New trade volumes at the ma jjgor CDS