The release of standard documentation for trading CDO credit default swaps in early June was a major step toward transforming what has historically been a long-only market - and in the weeks following, the sector seems to be chugging along.
Multiple CDO CDS bid lists have garnered strong participation, according to JPMorgan Securities. There is a generally constant negative basis to cash emerging in trades so far, with triple-B and double-B CDO CDS spreads for protection sellers averaging from 20 to 50 basis points inside cash spreads.
Despite the option of going short on the CDO market (using a relatively standard format), the market is still unsure about whether it has enough liquidity for players to cash in on implied CDS gains. As JPMorgan analysts pointed out last week, for a protection buyers to exit a trade they must find another protection buyer willing to step in - or satisfactory spread levels. If a credit event does occur, physical settlement is an option; cash settlement, however, is seen as an unlikely option, because dealers can include an implied write-down provision within trade documentation. Spread volatility at any time could make the CDS more erratic than the cash market.
Prior to standardization, dealers did participate in CDO CDS, but on a much smaller scale than what is anticipated for the market now. JPMorgan estimates there is about $1.8 billion in CDO CDS contracts currently outstanding on nonstandardized documentation.
The dealer community had a relatively difficult time agreeing on standardized documentation for CDO CDS contracts because of the complex nature of CDOs, as well as the smaller pool of secondary market liquidity. As recent as late May, dealers were still toying with the implied write-down provision of the trades (ASR, 05/22/06). The committed coordinated by the International Swaps and Derivatives Association settled on a 100% overcollateralization threshold for implied write-downs, which is one of the more aggressive proposals that were discussed, JPMorgan reported.
Both new-issue and deals that are seasoned by two to three years are the most popular reference obligation so far, JPMorgan said. The majority of trades have been variable cap, without an implied write-down.
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