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The European Central Bank’s head of supervision has called on global regulators to scrutinise trading in the market for insuring against a debt default, claiming it can trigger falls in a bank’s share price and threaten a run on deposits.
Andrea Enria, chair of the ECB supervisory board, said rule-setters at the Financial Stability Board, a global regulatory body, should review how the credit default swap market works after sharp moves in the price of such instruments preceded a sudden drop in the share prices of Deutsche Bank and other European lenders on Friday.
“With a few million you can move the CDS spread of a trillion-euro-asset bank and contaminate of course stock prices and possibly also deposit outflows,” Enria told a conference in Frankfurt. “So that is something that concerned me a lot.”
Answering a question about Friday’s share price fall at Deutsche Bank, Enria said the CDS market was “very opaque, very shallow and very illiquid”. He said there should be “more transparency” in the CDS market by shifting trading to central counterparty clearing.
“For instance, having these types of markets all centrally cleared, rather than having all these . . . opaque transactions going on somewhere, where you don’t know who is trading, I think that would already be great progress in this market,” he said.
Deutsche shares fell as much as 14 per cent on Friday, prompting German chancellor Olaf Scholz to reject comparisons between the country’s biggest bank and Credit Suisse, which was forced into the arms of its rival UBS in a weekend rescue deal. Shares in Deutsche have since partially recovered, but remain down a fifth in the past month.
The turmoil in the banking sector has thrown the spotlight on to the market for single-name CDS, which act like insurance and pay out if a company defaults, making them closely watched as an indicator of a company’s financial strength. The derivatives are thinly traded — in the final three months of last year there were on average only nine trades per day in Deutsche’s CDS even though it is one of the most traded, according to the US’s Depository Trust and Clearing Corporation, which runs a swaps data repository, although it is unclear how often they were traded this month.
Deutsche’s five-year CDS rose from less than 100 basis points two weeks ago to more than 200 basis points by Friday, as concerns grew that the German lender may be the next to come under pressure following three US regional bank failures and Credit Suisse’s forced sale to UBS.
Hedge funds were at the same time building their bets against Deutsche’s shares. Short interest rose from less than 2 per cent to more than 3 per cent — the highest level since May — over the same period, according to S&P Global Market Intelligence.
Marshall Wace, one of Europe’s biggest hedge fund firms, held a short position against Deutsche of 0.61 per cent of its shares as of Friday, according to a regulatory filing.
“Higher CDS spreads will put widening pressure on [a company’s] bond spreads across their capital structure as well as their stock price,” said Andrea Seminara, chief executive of credit-focused asset manager Redhedge.
“CDS spreads are usually correlated to a bank’s share price at times of market stress as both would reflect higher risk premium and concern on the credit quality of the bank,” he said.
Credit Suisse’s CDS this month rose from less than 400 basis points to more than 1,000 basis points, reflecting worries about its financial position, shortly before it was bought by UBS.
The gross market value of single-name CDS contracts rose to $108.5bn as of mid-2022, up by more than 50 per cent from a year before, according to the International Swaps and Derivatives Association.
Enria is expected to discuss tighter regulation of the CDS market with members of the FSB, which monitors financial stability and co-ordinates financial regulation. The FSB is chaired by Klaas Knot, the Dutch central bank head who also sits on the ECB’s governing council.
It was important to continue monitoring the viability of banks’ business models, which played a part in the demise of Silicon Valley Bank and Credit Suisse, Enria said. But he denied there was a need to overhaul global banking regulation in the wake of the recent failures, adding: “We should be very careful not to throw away the baby with the bath water.”
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