Will the MiFIR Review make single-name credit default swaps more transparent?

Single-name credit default swaps (CDS) are derivatives between two counterparties to ‘swap’ the risk of default of a borrowing reference entity. The buyer of the CDS needs to make a series of payments to the protection seller until the maturity date of the financial instrument, while the seller of the CDS is contractually held to pay the buyer a compensation in the event of eg a debt default of the reference entity. Single-name CDSs are mostly traded in over-the-counter derivatives markets with a lower level of pre-trade information (such as bid-ask quotes and order book information before the buy or sell orders are executed) and post-trade information (ie data such as prices, volumes, and the notional amount after the trade took place) compared to eg listed financial instruments.

In March 2023, three US banks ran into financial difficulties with spillovers to Europe where Credit Suisse needed to be taken over by USB. During this financial turmoil, EU banks’ CDSs rose considerably in terms of prices and volumes. For Deutsche Bank, there were even more than 270 CDS transactions for a total of US 1.1 billion. On 28 March 2023, the press reported that regulators had identified that a single CDS transaction referencing Deutsche Bank’s debt of roughly 5 million EUR conducted on 23 March could have fuelled the dramatic sell-off of equity on 24 March causing Deutsche Bank’s share price to drop by more than 14 percent.

One of the conclusions drawn by regulators, such as the European Securities and Markets Authority (ESMA), was that the single-name CDS market is opaque. The Depository Trust and Clearing Corporation (DTCC) provides post-trade CDS information, but the level of transparency is not perfect given that eg only information on the top active instruments is disclosed. Regarding pre-trade information, trading is conducted mostly through bilateral communication between dealers. However, even when screen prices are available, they are only indicative and most dealers will not stand behind their pre-trade indicated price because the actual price the dealer will transact with is entirely subject to bilateral negotiations. For the large majority of CDSs that are traded over the counter, the level of pre-trade transparency is thus low, also because all transparency requirements of the Markets in Financial Instruments Regulation mainly apply to market operators and investment firms operating regulated markets, multilateral trading facilities, and organized trading facilities. Even for those instruments traded on a trading venue, there is the possibility to obtain a waiver as they do not fall under the trading obligation and are considered illiquid financial instruments. Because of their illiquidity, the large majority can also benefit from post-trade deferrals allowing for disclosures to be made four weeks after trading.

Regulation (EU) 2024/791 (‘MiFIR Review’) was published in the Official Journal of the European Union on 8 March 2023. In the late stage of the negotiations, as a consequence of eg a letter by ESMA on the MiFIR Review, a provision was inserted requiring that trades on CDSs that are centrally cleared and reference global systemically important banks (G-SIBS) or an index comprising such banks, are subject to pre- and post-trade transparency rules. The reason is that these CDSs might fuel speculation on the creditworthiness of such banks. It has to be highlighted that single-name CDSs do not fall under the mandatory clearing obligation of the European Market Infrastructure Regulation (EMIR) and hence only those instruments that are voluntarily cleared have to be transparent. This entails that data on single-name CDSs referring to G-SIBS that are not cleared or CDSs referring to other reference entities do not need to be made transparent given that the clearing obligation is not in force for these instruments. Co-legislators are also of the view that the duration of deferrals has to be determined utilizing regulatory technical standards, based on the size of the transaction and liquidity of the class of derivatives. The MiFIR Review states that the arrangements for deferred publication will have to be organized by five categories of transactions related to a class of exchange-traded derivatives or of over-the-counter derivatives referred to in the pre-trade transparency requirements. ESMA thus will need to determine which classes are liquid or illiquid as well as above which transaction size and for which duration it should be possible to defer the publication of details of the transaction.

Besides the pre-and post-trade transparency requirements, the MiFIR Review also focuses on the design and implementation of a consolidated tape. This consolidated tape is a centralized database meant to provide a comprehensive view of market data, namely on prices and volumes of securities traded throughout the Union across a multitude of trading venues. The tape will be created by data coming from trade repositories and approved reporting mechanisms (APAs). The MiFIR review is more specific now on the information that has to be made public by an APA concerning OTC derivatives, which will flow into the consolidated tapes. Information with respect to those single-name credit default swaps which are centrally cleared and reference a global systemically important bank  or an index comprising global systemically important banks, will thus need to be reported to the consolidated tape.

In my recent working paper, I claim that the MiFIR Review is not far reaching concerning the revised transparency requirements for single-name CDSs given that those referring entities that are not a G-SIB are not majorly impacted. Given that CSDs referencing G-SIBS represent only a small fraction of the market (according to DTCC data, 8.36% based on the total notional amount traded and 5.68% based on the number of transactions), the MiFIR Review does thus not cover a large percentage of the market. In addition, single-name CSDs referring to G-SIBS that are not centrally cleared are also not affected. Knowing that there is no clearing obligation on CDSs because they are not sufficiently liquid, a large fraction will not be impacted or can continue to benefit from pre-trade transparency waivers or post-trade deferrals.

Nevertheless, based on an extensive literature review, my article comes to the conclusion that more severe transparency requirements as foreseen by the MiFIR Review could not be beneficial in the first place. A large number of academic and industry opponents state that enhanced transparency can be detrimental as it could discourage dealers from providing liquidity: in a market in which there are few buyers and sellers ready and willing to trade continuously, asking for more transparency could lead to even less liquidity as the limited number of liquidity providers would be obliged to make their trading strategies available, weakening incentives to trade. A total lack of transparency might thus be undesirable, but for an illiquid CDS market, full transparency might dissuade traders even more from trading. To conclude, the MiFIR Review strikes an appropriate balance by reducing the level of opaqueness while not harming liquidity.

The author’s complete article can be accessed here.

Randy Priem is Professor of Finance at UBI Business School (Middlesex University London) and at Antwerp Management School (University of Antwerp), as well as Coordinator of the Markets and Post-trading Unit at the Belgian Financial Services and Markets Authority. The views in this post are his own and do not necessarily represent those of the forementioned institutions.