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MDX & CDX
Markets have validated and advanced the design of CDX over the past 20 years, and dozens of new indices have been introduced to cover North American and emerging debt during that period. MDX marks a new evolution in credit default swap indices. By applying structural elements of CDX to the $13tn mortgage market, MDX reflects the fundamental credit differences between corporate and mortgage borrowers through tradable instruments that can be readily understood and used throughout capital markets.
In this article, we review the technical design similarities between MDX and CDX and explain the necessary adaptations to reflect the fundamental credit differences between products. In turn, we discuss the expected benefits to the MDX, mortgage credit, and cross-asset markets.
| Specification | CDX IG | CDX HY | MDX |
|---|---|---|---|
| New Series Frequency (months) | 6 | 6 | 6 |
| Index Reference Obligors | 125 | 100 | >400,000 |
| Weighting | Equal | Equal | Equal |
| Initial Swap Tenor (months) | 63 | 63 | 63 |
| Fixed Leg Coupon Rate (bps) | 100 | 500 | 200 |
| Payment Dates | Quartertly | Quartertly | Quartertly |
| Cash and/or Physical Settlement | Cash | Cash | Cash |
| Credit Event Notice | S&P | S&P | ICE Data |
| Clearinghouse | ICE Clear | ICE Clear | ICE Clear |
| Price Reporting Systems | ICE, DTCC | ICE, DTCC | ICE, DTCC |
| Trading Venue | SEF | SEF | SEF (expected) |
| Trading Convention | Spread => $ PX | $ PX | Spread => $ PX |
Technical similarities yield important benefits in facilitating user adoption of MDX and eliminating structural pricing differences versus CDX. The familiarity, simplicity, and transparency of these attributes will ease the introduction of MDX to the marketplace. Market participants can incorporate MDX swaps into their analytics, systems, and trading protocols by utilizing elements of their existing CDX infrastructure3. In addition, the CDX-MDX similarities mitigate instrument idiosyncrasies, allowing fundamental credit differences between MDX and CDX to act as a primary driver of relative performance.
Technical differences between MDX and CDX are designed to mirror the periodic frequency of mortgage borrower stress relative to corporate borrowers. Mortgage borrower credit performance is reported monthly, while corporate borrowers experience Credit Events on an episodic basis. Accordingly, CDX issues new versions of an index upon the determination of a Credit Event, while MDX calculates Credit Events and writes down the notional value of swaps monthly using an index-based factor. Since Credit Events occur monthly throughout the life of the swap, MDX floating rate payments from the swap seller to the swap buyer will have a much different pattern than those of CDX – and deliver high correlation to mortgage credit performance. Certain technical adaptations from CDX to MDX are highlighted below:
| Specification | CDX IG | CDX HY | MDX |
|---|---|---|---|
| Credit Event Definition(s) | Fail to Pay, BK | Fail to Pay, BK | 120 Day Deliquent, Modification |
| Floating Leg Settlement & Recovery | Auction, Variable | Auction, Variable | Monthly, Fixed 0% |
| Notional Value | Fixed | Fixed | Declines Monthly with Credit Events |
| Interest Accrual Rate | Same for Payment Period | Same for Payment Period | Declines Monthly with Notional Value |
Fundamental Differences between MDX and CDX are reflected in differing credit performance (household vs. corporate) and the treatment of Credit Events. While broadly correlated, household credit behavior (MDX) and corporate credit behavior (CDX) diverge based on both causes and frequency of borrower stress. In general, Credit Events are far more frequent in MDX than both CDX IG and HY. In index terms, MDX Credit Events are treated with 100% severity as compared to varying recovery outcomes for CDX, enabling timely processing of floating rate swap payments. These distinctions will be reflected in the trading prices between MDX and CDX.
MDX Trading and Liquidity are expected to benefit from the ability to execute MDX and CDX side by side. During the early MDX adoption phase, the emergence of a predictable “basis” between MDX and CDX will encourage liquidity to flow between the two markets. A stable basis during normal trading conditions can allow market participants to manage outsized exposures in MDX by using offsetting CDX positions, particularly as the MDX market matures. It will also allow mortgage investors to move CDX hedges to MDX while maintaining an appropriate level of liquidity.
Basis Trading — both between cash and derivatives and among derivatives — is a popular strategy across capital markets. Consequently, it is expected that MDX/CDX basis trading will become an important feature of both MDX and CDX swap trading. This strategy may be eligible for the capital benefits of cross margining under ICE Clear Credit’s portfolio margining program. In future articles, we will examine basis trading in more detail and show how fundamental performance differences between MDX and CDX can be evaluated.
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