Negative basis trade volumes, one of the mainstays of credit derivatives prop trading over the past year, have plummeted because dealer risk managers are concerned the risk is too high for the reward. In the trades banks fund themselves at around LIBOR flat to purchase AAA bonds and simultaneously buy protection in the credit-default swap market from a monoline insurance company. The bank pockets the spread difference between the funded bond and the unfunded default swap.
Rick Watson, head of structured finance at FGIC UK in London, said risk managers at the dealers are pulling in the reins on these trades because the profit has reduced to about 20bps by such active trading.
Scott Eaton, managing director and head of principal investments at the Royal Bank of Scotland, said, "Negative basis trades don't work with anything like the attraction they used to." Jonathan Laredo, partner at Solent Capital Partners in London, agreed, saying, "The banks have reduced this arb so that it makes it harder."
