What the TF: Fixing Broken CDX Indices – It’s NOT Rocket Science

While everyone is talking about “broken” indices, let’s look at 5 ways to fix it. Some are very easy, some are more difficult.

Exchange Traded

Force all the indices on to exchanges with standard collateral provisions. It will be hard to avoid some off-exchange trades, but this would be a big step in terms of controlling size and creating transparency. Have “margin” a function of the “worst of” mark to market and fair value. That would ensure that those hurt by the market price are paying appropriate collateral, and those at risk to a snap back to fair value (which happens regularly, and usually quickly) also have appropriate collateral. It is bordering on shameful that more than 4 years after Bear Stearns so little progress towards exchange traded CDS has been made. Even clearing and SEF’s seem to be taking far longer than they should.

Right to convert to single names

As much as these are called “indices” they really are portfolio trades. The document reads exactly as 125 single name contracts. In the original TRACERS which was a 40 name Morgan Stanley product, you had the right to convert to single name trades. With the SNAC protocol the risk of doing this is less than it used to be. It would ensure that the index stays in line with fair value. It would let people “collapse” the arb, where they bought index and sold single names (or vice versa). That would let a lot of trades drop out of the system, reducing counterparty exposure and complexity at the same time. If it looks and acts like a portfolio, it is, so why not look at putting this old “feature” back in. It comes with some risks, but if the index and single names are all exchange traded, it actually works very very well.

Market Weighted as Opposed to Equal Weighted Indices

The CDX indices are equal weighted rather than market weighted as most traditional indices are. That means names like MBIA and Radian make up a disproportionate amount of the CDX index relative to their importance to the bond market as a whole. When indices contain a big concentration of poorly followed, but dangerous names, their tendency to deviate from “fair value” increases, since those names drive fair value the most and are not that liquid. For all the “complaints” about ETF’s, I hear that real money clients like them because they better reflect the make-up of their portfolio than the equal weighted CDS indices do.

Make it a proper index with name replacement rather than “rolls”

The S&P 500 has changed at least 20% of the names since Lehman, yet it is still called the S&P 500, people run historical models based on the index as it once was. It performs like an index. Here we have IG1 still around in “10 years” with is a March 2014 index, all the way out until IG18. It seems ridiculous. The industry has figured out an “auction” process for Credit Events, so maybe they can figure out a process to “replace” names in the index rather than “rolling” it. Name changes aren’t that common, and a process to get single name positions on the names coming out could help that. It would be hard for tranches, but frankly, who cares that much about synthetic CDO’s at a regulatory or systematic level? This is the hardest evolution, but should occur, or at least be looked at.

Futures on bond indices or ETF’s

Is that the next evolution? Diminish the importance of CDS by creating viable, tradable futures contracts on bond indices or ETF’s?

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts