The Credit Default Swap vs. Repo Trade

Finadium
February 2012

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The Credit Default Swap (CDS) trade has come under fire lately, not only from European regulators looking to reduce investor use of naked swaps but also from the unique attributes of CDS contracts that may leave investors in a “voluntary” Greek restructuring without the protection they thought was there. As the allure of CDSs wears thin, some hedge funds and other investors are looking more closely at the repo trade.

Although there are important differences between the two products, the similarities and overlap between CDSs and repo are compelling. On the surface, the CDS market feels more digestible than shorting the equivalent cash bond and obtaining financing; CDS cash flows have fewer moving parts. However, the terms of CDS contracts means that there is enormous complexity just below the surface. Repo on the other hand may offer clearer contractual obligations but changes the economic outcome of the trade in subtle but important ways.

This report looks at the details underlying the trading of CDSs and repo products, including modeling exposures to haircuts and financing rates based on current market practice. Our conclusion shows that understanding the differences between these products yields an investment preference for different types of investors, including those that are betting against the economic outcome of a bond and others that want to hedge their existing exposure.

This report should be read by market professionals that trade CDS or repo, by corporate treasurers looking to hedge their exposures, and by service providers looking to advise their clients on the best ways to achieve their investment objectives.

This report is 39 pages with 11 exhibits.

TABLE OF CONTENTS
■ Executive Summary

■ The Relationship Between CDS and Repo

■ The Mechanics of CDS and Repo Flows
– CDS Flows
– The “Big Bang” and the “Small Bang”
– Trade Compression
– Repo Flows

■ Relative Advantages of CDS vs. Repo Trades

■ The Self-Destruction of the Basis Trade

■ Modeling Changes to Repo Rates and CDS Haircuts

■ Greece vs. Investors in the CDS Market

■ The Yin and Yang of CDS and Repo

■ Appendix A: CDS Market Standardization from
the “Big Bang” and “Small Bang”

■ About the Author

■ About Finadium