Deutsche Bank Trims CDS Trade Amid Stricter Laws
Tighter regulations and a weak trading scenario have led to the gradual fading of the credit-default swaps (:CDS) trade, which was once one of the lucrative sources of revenue for banks. Hogging the limelight, Deutsche Bank AG (DB) is set to exit from most of its trading in CDS, a derivative contract used to protect against losses. The news was first published by Bloomberg.
The company intends to cease trading in investment-grade (IG) and high-yield (HY) corporate credit swaps in U.S. and European companies, collectively known as “single name” CDS. However, the German banking giant will focus on corporate bonds transactions, while continuing to trade in strong markets for credit swaps tied to benchmark indexes. The company will also continue swaps trading tied to emerging-market borrowers and distressed companies.
Notably, Deutsche Bank possessed a solid foothold in single-name CDS for several years.
CDS Market: Falling from Heights
Prior to the financial crisis, the credit swaps business grew rapidly as it generated huge profits to several major global banks. However, experts believe that uncontrolled growth of this risky business is one of the reasons behind the 2008 financial crisis.
The collapse of Lehman Brothers Holdings Inc. and the government rescue of American International Group, which had sold swaps agreeing to pay investors for soured mortgages, had changed the scenario for CDS trading. The Dodd-Frank financial overhaul in 2010 made swap trading costlier for banks.
Previously, CDS trading were privately negotiated between parties, which benefited banks as they controlled access to the market and derive huge gains from the contracts. However, per the latest rules of Dodd-Frank, most index swaps require to be traded on regulated platforms which would aid in greater transparency. Also, such trades need to be processed by clearinghouses that charge fees for providing guarantee of the trades. The Securities and Exchange Commission (SEC.TO) has not yet mandated single-name credit swaps to comply the trading and clearing requirements, which would reduce their liquidity.
Further, with improvement in the credit worthiness of the borrowers, protection sellers are receiving less premiums, which ultimately is resulting in margin compression. Also, with the persistent decline in volatility, buyers of protection are not enticed to purchase protection.
The CDS market has tanked to $19.5 trillion in contracts as of Jun 2014, from $58 trillion at the end of 2007. Also, single-name CDS outstanding have declined to around $11 trillion from over $30 trillion in 2007.
Bottom Line
While industry headwinds have forced Deutsche Bank for the latest move, we believe it will benefit the company in the long run by offloading such non-strategic operations.
However, the company is facing legal issues related to its business conduct in the CDS market. Owing to a ruling in September in the US District court, investors may pursue a lawsuit against several global banks including Deutsche Bank, The Royal Bank of Scotland Group plc (RBS), The Goldman Sachs Group, Inc. (GS) and Barclays PLC (BCS) for artificially inflating prices and restricting competition in the CDS market, which constituted a violation of the U.S. antitrust law. (Read more: 12 Global Banks May Face Credit Default Swap Antitrust Suit)
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