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Creating liquidity from illiquid stuff

Creating liquidity from illiquid stuff

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A quick take on a long-running theme in markets, especially fixed-income.

Investors are reaching for a toolkit of exchange traded funds, mutual funds and credit derivatives to make up for a dearth of liquidity in parts of the financial system, according to market participants and research from Barclays.

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Many have turned to ETFs, mutual funds and certain derivatives to make up for a lack of liquidity. ETFs use a network of banks and trading firms to give investors cheap and instant exposure to a wide variety of assets.

The trend is particularly pronounced in the fixed income market, where new rules aimed at increasing bank capital and reducing the risk of a run in the “repo market” — Ground Zero for the financial crisis — are said to have most hurt ease of trading.

Risks squeezed out of banks pop up elsewhere

 

New column – Asset managers, repo and derivatives. Oh my!

New column – Asset managers, repo and derivatives. Oh my!

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Chances are, when you think of the repo market you think of banks and broker-dealers and the craziness that went down in 2008. This column, based on an amazing research paper by Zoltan Pozsar, suggests that’s a mistake.

(Bonus: It calls out Pimco on window-dressing its balance sheet)

Here’s an excerpt:

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Tourists caught on the wrong side of the volatility trade?

Tourists caught on the wrong side of the volatility trade?

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We know that banks and hedge funds a traditional sellers of volatility. But low interest rates and somnambulant markets have also encouraged asset managers (or “tourists” as the banks and hedgies sometimes call them) to take up the strategy as they seek to juice their returns. It seems … risky.

This story has a lot of stuff in it, including a smallish dive into the events of October 15.

Long the domain of professional speculators like big banks and hedge funds, “selling volatility” — as such wagers are known — became one of the most popular trades of the year as a much wider range of investors piled into bets that asset prices would remain stable.

Now, as the prospect of the Federal Reserve raising interest rates draws increasingly near, the concern is that market volatility will return with a bang in 2015 and those investors caught on the wrong side of the revival will suffer badly.

“Volatility is a zero-sum game — for every buyer there is a seller. But what has changed is the type of sellers,” says Maneesh Deshpande at Barclays.

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Caught on the wrong side of the ‘vol’ trade

Synthetics, derivatives and leverage – oh my!

Synthetics, derivatives and leverage – oh my!

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Wall Street banks are encouraging the use of derivatives including total return swaps (TRS), credit index options (swaptions) and variants of the synthetic collateralised debt obligations (CDOs) that proved so disastrous during the previous financial crisis in an effort to serve investors the yield they so desperately crave.

(The crucial difference this time around, is that these are tied to corporate credit rather than residential home loans).

Read the following, and weep/laugh as you see fit.

Boom-era credit deals poised for comeback (December, 2013)

Last month Citigroup placed an unusual job advertisement. The bank was seeking an analyst able to crunch the numbers on an obscure financial security: synthetic collateralised debt obligations. Four weeks later, job applicants would find the position filled. Such has been the clamour among investors for the higher yields from higher-risk products that big banks including Citi, JPMorgan Chase and Morgan Stanley are turning again to the more esoteric parts of the financial markets.

Turning to total return swaps (July, 2014)

A type of derivative known as a “total return swap” has become a hot ticket item on Wall Street as investors seek out new ways of playing booming credit markets, while banks – including Goldman Sachs – find fresh methods to finance their assets.

Investors dine on fresh menu of credit derivatives (August, 2014)

The renewed boom in credit derivatives is being powered by yield-hungry investors and Wall Street banks looking for new revenues. The two instruments helping investors play booming corporate credit markets at this juncture include total return swaps (TRS) and options on indices comprised of credit default swaps.

Derivatives of derivatives

Derivatives of derivatives

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While the outstanding amount of CDS has been shrinking, there is one pocket of the derivatives world that appears is growing pretty substantially – options on CDS indices. How much have these CDS index swaptions grown, you ask?

From a 2011 FT Alphaville post:

…. Citigroup revealed in “a brief CDX options primer” that the market for these financial instruments had surpassed an average $5bn in trading volume per week. And that’s just for options based on Markit’s CDX index — not even those on other credit indices …

Fast forward almost three years, and the latest estimate for weekly volume is, erm, somewhat higher.

… An average $60bn of CDS index options currently exchange hands per week … according to estimates from Citigroup based on data from the Depository Trust & Clearing Corporation (DTCC)….

CDS options market multiplies alongside questions (2011)
‘Swaptions’ trade leaps over regulatory hurdles (2014)