Post-Crisis Regulation and the CDS-Bond Basis

Summary

The document explains why the CDS-bond basis could be close to zero before the global financial crisis even though funding was not free. The answer attributes this to the relative funding costs of the two positions: before the crisis, holding a cash bond and taking equivalent credit exposure through a credit default swap had similar funding costs, so the basis remained near zero.

After the crisis, the relative cost of holding physical bonds rose. Bond inventory uses bank balance sheet capacity, which became scarcer under post-crisis conditions and capital rules. CDS exposure may create trading risk without tying up balance sheet in the same way, so banks can charge more internally for cash-bond positions. Although arbitrage trading could in principle narrow the resulting basis, capital constraints and risk controls may prevent traders from doing so. This is a qualitative explanation, not a detailed empirical analysis; it does not quantify the regulatory effects or address all market-specific factors that can influence the basis.

Key ideas

• A near-zero pre-crisis CDS-bond basis is attributed to similar relative funding costs for bonds and CDS positions.
• Post-crisis, physical bond inventory became more costly to banks because it consumes scarce balance sheet capacity.
• CDS positions can create trading risk without the same balance sheet burden as owning bonds.
• Capital rules and risk controls may limit arbitrage that would otherwise narrow the basis.
• The explanation is qualitative and does not measure the size of each contributing effect.

Tags

# Why was CDS-bond basis close to zero before the financial crisis?


# Why was CDS-bond basis close to zero before the financial crisis?












For instance, see the evidence here:

This paper claims that this arises from the fact that cash bond and CDS have different margins, and thus it is cheaper (funding wise) to hold CDS positions. However, funding cost wasn’t zero before crisis, so what explains the almost zero basis pre-crisis?

(http://faculty.haas.berkeley.edu/garleanu/MLoOP.pdf)

## Answer by demully (score 8)

https://quant.stackexchange.com/a/64193

You and the paper are both correct.

Funding was not free before the GFC, but the funding cost of both positions then was almost equal, generating almost-zero basis.

Since then, holding physical bonds has become relatively more expensive, because these tie up bank balance sheet, which has become a scarce resource since the GFC. Or at least a scarcer resource than their trading VaR, which is what CDS positions generate.

Essentially, banks now charge their traders more for holding physical bond inventory than for the equivalent trading risk of the same economic exposure via CDS. Which is what generates the basis you've highlighted. The banks' traders would arb this out if they could; but their risk officers won't let them. Because the capital adequacy rules associated with holding a credit portfolio creates a different regime from that trading credit risk without balance sheet liabilities.

It's the relative change in the regulatory treatment of the two since the GFC that's key here. Relative being the operative word here.

hope this answers and helps, DEM

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.