Decoding Derivatives – Q1 2021

Europcar Drives CDS Down a Familiar Path

When Europcar defaulted on its debt, buyers of approximately $100 million of credit default swap (CDS) protection expected significant payouts due to the anticipated low recovery on Europcar bonds and loans. However, a short squeeze in the CDS auction resulted in a CDS final price of 100, representing a zero recovery for protection buyers on their CDS contracts. Short squeezes are not a new phenomenon in CDS. In the case of Europcar, the squeeze resulted primarily from the vast majority of bonds and loans being locked up as part of restructuring negotiations, limiting supply of the debt for the purposes of the CDS auction. This is yet another issue CDS market participants have to grapple with when dealing with a company in the process of restructuring, in addition to the risk of all deliverable obligations disappearing, as was the plan in the case of Thomas Cook, where the debt was scheduled to be converted into equity. Europcar is a reminder that the liquidity of deliverable obligations for the purposes of a CDS auction may not be taken for granted, and that assuming such liquidity can be a fool’s game, making naked CDS inherently riskier.

Subcode: DC Disclosure Remains Mysterious

As is common for significant determinations, the DC received arguments from market participants in Europcar regarding the credit events itself and the eligibility of certain loans as deliverable obligations for purposes of CDS settlement. While the DC noted that it had considered such requests and disclosed what appears to be a partial summary, it did not publish a copy of the credit event determination requests or the deliverable obligation submission. Whether this indicates a new approach by the DC with respect to disclosure remains to be seen. The DC has indeed been grappling with disclosure issues for quite some time, and a number of approaches have been considered in that regard. Regardless, this is a reminder that any supporting argumentation submitted by market participants to the DC in connection with a request or determination may not be disclosed by the DC secretary to the DC members, let alone made public on the DC website in its entirety (or at all) for a variety of reasons. As such, market participants may or may not get to see the totality of argumentation submitted to the DC in connection with a particular determination. In turn, a lack of publication by the DC does not mean that activist market participants are not acting behind the scenes. Market participants should be aware of those dynamics when considering whether to actively make submissions to the DC.

Subcode: Buyer Beware

Europcar exhibited many of the same cautionary tales for CDS protection buyers as other events have over the past few years, presenting yet another trap for the unwary CDS protection buyer. CDS protection buyers should be aware of the risk posed by a lack of liquidity of deliverable obligations when compared to the net notional amount of CDS outstanding. A lack of liquidity in deliverable obligations paired with a sizable net open interest in the CDS auction can lead to a short squeeze, where the lack of supply to meet demand for the debt results in the final price of the CDS auction being inflated, sometimes to par as with Europcar. In the case of Sears, the short squeeze occurred due to market supply issues and the control of demand by a large CDS protection seller. In Europcar, the short squeeze appears to have primarily occurred due to deliverable obligations being locked up as part of restructuring negotiations. Both cases demonstrate that, in order to protect its investment, a CDS protection buyer inherently relies on the availability and liquidity of deliverable obligations in the CDS auction, which may not be in the CDS protection buyer’s control. Where a CDS protection buyer is also invested in the debt (either as a hedger or basis holder), that may require the CDS protection buyer to ensure some of those obligations remain unrestricted so as to provide liquidity in the auction or, at a minimum, to enable it to deliver the debt into the CDS auction, which in a situation like that of Europcar, would have enabled CDS protection buyers to monetize their CDS positions (by selling discounted paper at par via the CDS auction).

CDS Volume Up and Down

CDS trading volume has experienced similar volatility to the markets in general over the past 12-18 months. While average weekly volumes were up in 2020 compared to 2019, Q1 2021 showed a decline in volumes compared to the same period in 2020. This Q1 2021 contraction is likely due to heightened trading in Q1 2020 driven by early pandemic trading activity. It remains to be seen whether the Q1 declines are indicative of a sustained market contraction from an anomalous 2020 or the trade volumes will pick up later in the year. The CDS market will be hoping that 2020 is a sign of growth for the product and that the remainder of 2021 continues that upward trend ($9.7 trillion in notional amount across all instruments at the end of 2020, up 15% from 2019). U.S. index trades (CDX) decreased by around a third in both notional and trade count compared to Q1 2020.

Succession Events Blooming

With CDS often a key component in any restructuring conversation, the occurrence, or not, of a succession event is perhaps the most prevalent CDS event across the market as a whole. Succession events can occur as a function of a merger or business combination, as was recently the case for Peugeot, or by virtue of a corporate structural change such as that of Unilever. Succession events can also occur as a result of a debt restructuring or a refinancing, such as in the case of AK Steel (where the refinancing was prompted by a merger of AK Steel with Cleveland Cliffs). Any proposed refinancing that may entail debt exchanges across affiliates of a Reference Entity will typically catch the attention of CDS traders. This is particularly true in instances where there is a risk of value transfer because of differing CDS spreads at different affiliates or, for basis traders, if the debt exchanges do not result in any succession event for the CDS contract (or an insufficient one), as the CDS basis could get “broken.” This issue caught the market’s attention in the case of Nabors Industries, where there was some speculation as to what the company could have done to harm the interest of CDS holders. Where a debt restructuring or refinancing is involved, the devil is in the details for a succession event, and transactions can be structured to achieve a particular outcome in that respect. A case in point is AK Steel’s succession event, where even though essentially all debt at AK Steel was refinanced or retired, only 50% of the CDS migrated to Cleveland Cliffs (instead of 100%) due to the settlement timing of one debt exchange transaction as part of the broader refinancing transactions occurring upon the closing of the merger.

CDS Trading Resists the Winds of Change

As the financial markets trend more and more toward automated processes, the CDS market appears resistant and lags behind. Indeed, equity and bond markets are largely driven by automated execution and are subject to vast volumes of algorithmic trading. CDS, however, is still largely traded and executed by human traders on a desk. While the uniform nature of CDS lends itself to automation and the prominence of periodic roll dates presents an opportunity for automation to increase efficiency, there is clearly a market reluctance to go down that path. Swap execution facility (SEF) data indicates that while most CDS trade volume flows through SEFs, very little adopts the automated trading capability provided by those same facilities. While technology advances are driving market changes, it appears that trading platform providers need to continue working with CDS market participants to create a desirable solution.