30 September 2016

Financial Times: Deutsche Bank puts CDS market to test

As Deutsche Bank’s share price has swung dramatically throughout the week, traders have also fuelled demand for another type of security: the credit default swaps that offer insurance against a default by the lender.

While Deutsche Bank CDS remain the most liquid securities in the sector, some market players are growing concerned that capital constraints imposed by regulators might impede the ability of market-making banks to keep these securities trading freely.

This pressure, they say, may grow ahead of the upcoming quarter end, because “credit valuation adjustments” — a routine re-evaluation of counterparty derivative risk carried out by banks and trading institutions — can require the purchase of CDS protection.

One major concern is that, without the capacity to buy CDS protection directly, market players will instead look to short sell Deutsche Bank shares, or withdraw collateral from the bank to reduce their credit exposure. This could exacerbate the sell-off in the German lender’s shares, triggering a negative feedback loop that only increases the need for credit protection.

Since a bank with a short position in Deutsche credit would have to pay out just when the shorting market is most likely to be under stress, this would impose a higher capital charge — leading to a reluctance to make markets.

Full article on Financial Times (subscription required)

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