Securities regulators should look to boost post-trade transparency in credit default swaps (CDS), the International Organization of Securities Commissions (IOSCO) says in a report that examines the latest major episode of banking system stress in early 2023.
On Tuesday, the umbrella group of global regulators issued a report analyzing the single-name CDS market and its functioning in March 2023, when parts of the banking system ran into trouble, resulting in several high-profile bank failures in the U.S. and elsewhere.
Among other things, the report found that activity in the CDS market ramped up during the banking sector turmoil, as investors sought portfolio hedges in a climate of rising uncertainty. That increase in trading activity in a market segment with relatively low liquidity also led to a widening in trading spreads for bank CDS, it noted.
In turn, “The increase in CDS spreads, coupled with the decline in equity prices, served as indicators of heightened stress,” the report said.
Yet, the review didn’t find any evidence of causation “between sharp movements in the prices of single-name CDS and the subsequent sudden drop in the shares of certain banks at the time.”
Ultimately, the report concluded that the CDS market could benefit from greater post-trade transparency, which may have various potential benefits. This includes the potential to reduce information asymmetries and lower transaction costs, which could promote greater price efficiency and encourage more market participation, “thereby increasing liquidity and competition, reducing regulatory arbitrage and market fragmentation, and providing more comprehensive information to make trading and valuation determinations.”
However, the report also acknowledged that there are possible negative impacts to increased transparency too — such as increasing the cost of hedging, particularly in illiquid markets that may not benefit much from greater transparency.
Other possible negatives could include “exacerbating market volatility, increasing opportunities for market manipulation, and impacting risk management practices and access to financing,” it said.
Overall though, the report recommended that regulators “take steps toward enhancing post-trade transparency” in their local CDS markets — provided that there won’t be a “substantial negative effect on market risk exposure or market activity.”
The report noted that so far, post-trade transparency requirements have only been adopted in the U.K., the U.S. and the European Union — developments that followed a 2015 report from IOSCO that also called for increased transparency in the CDS market.
Yet, various other markets — including Canada, Japan, Hong Kong, Singapore, Switzerland and Australia — don’t currently have transparency requirements for single-name CDS contracts (apart from aggregated data).
Alongside the call for enhanced transparency, the report reminded regulators to address potential suspicious activity in the CDS market through enforcement.
“This report provides an in-depth analysis of single-name CDS markets in major jurisdictions and identifies potential benefits with respect to increasing post-trade transparency, including reduced information asymmetries and greater price efficiency,” said Jean-Paul Servais, chair of IOSCO’s board, in a release.
The report “also aims to assist member jurisdictions in taking steps towards enhancing post-trade transparency should they conclude that such efforts would not have substantial negative effects,” Servais added.
In the meantime, IOSCO said it will continue to monitor developments in the CDS market and “consider appropriate next steps.”