Credit derivatives have been the hottest and fastest growing sector of the over-the-counter (OTC) derivatives market for some time now, drawing in players in ever-greater numbers.
And, according to the British Banker’s Association, the $5400bn credit derivatives industry is expected to reach as much as $8600bn by next year.
Although that is excellent news for bankers that make it their business to sell and trade credit derivatives, it is probably worrisome to regulators, some of whom have voiced concerns about the industry. The UK’s Financial Services Authority (FSA) recently outlined its worries about the backlog of unsigned credit derivatives confirmations – some of which it said remained unconfirmed for months. It said this raised “serious issues for market efficiency and confidence” and suggested that some financial institutions were failing to ensure that their operations were run efficiently.
The FSA’s comments caused some upset in the dealer community, several members of which privately voiced their own worries that the regulator was failing to keep up to speed on developments in the industry. If it has failed to do so, many argue that this is hardly surprising: so fast has the market developed that even the dealers are hard pushed to keep up with every new technology.
In with the new
Since the first credit default swaps emerged in the 1990s, innovation has been rapid. New financial technologies have emerged in quick succession and a flurry of acronyms that test the memory of all but the most attentive observers and practitioners: CDOs, CMCDSs, EDSs, RDSs, DDSs, HDOs and EDOs. The list goes on.
Andrew Whittle, European head of credit derivatives at Barclays Capital, is enthusiastic about the pace of development. “The credit derivative market has matured very fast and thus [has] quickly taken on the shape of a true derivatives market,” he says. “We are probably now at the stage the equity derivatives market was seven years ago: we have a full credit curve in maybe 200 credits, a liquid index product with narrow bid offer [spreads], and an options market. We are already starting to see constant maturity credit default swap (CMCDS) business and options products. And in the future I think we will see almost all variants of the interest rate or equity derivatives market emerge in the credit space.”
Despite Mr Whittle’s optimism about the raft of new products, there has been relatively low volume in many of these products. Index-based instruments, such as those from Dow Jones’s iTraxx, and synthetic collateralised debt obligations (CDOs) and the many variations on the CDO theme, may now be par for the course but products such as equity default swaps (EDSs), recovery and digital default swaps, equity default obligations and credit spread warrants have yet to see the serious volumes that justify the cost and effort put into their development.
Marcus Schuele, integrated credit marketing at Deutsche Bank in London, says: “EDS, recovery swaps and default baskets currently experience rather limited trade volumes. They are all useful adjuncts to the markets and the products do have their various uses but these are not being used actively at present.”
Opinions differ about why some of the newer products have yet to take off. Jakob Due, credit derivatives strategist at JPMorgan, believes that one reason for slow take-up is the speed of innovation in credit in the past couple of years. “Clients need time to digest the new products – index products, tranches on indices, options on CDSs and indices, CMCDSs – the list is endless, and it takes time to get to grips with the products and establish the necessary back-office infrastructure,” he says.
Marketing problems
Mr Schuele agrees: “Some of these products, like tranches or options, require a considerable marketing effort on behalf of banks to ensure clients are aware of them, understand them and are able to exploit their use. As there are so many new products, and a relatively high number of new entrants to the credit markets, there are not enough resources to address them all at once.”
According to Cameron Munro, director at Reoch Consulting, many credit products will take longer to gain critical mass than their interest rate equivalents because their growth has been driven primarily by one constituency. “The FX and interest rate markets always had a fairly evenly matched hedger and investor side. The credit derivatives market at present is driven from the investor side and there is still a lack of natural hedgers,” he says. “The corporate sector, for example, has yet to show the same sort of appetite even for the simpler credit derivatives that they did for early interest rate and forex derivatives.”
Looking for liquidity
The complexity of the credit market can also make it difficult to build user acceptance, says Mr Munro. There are few interest rate curves in the interest rate market therefore each curve generates significant activity and it was relatively easy to make the leap to second-generation products. By contrast, there are hundreds of credits in the credit markets and each is different, making it far more difficult to generate liquid markets across all the curves.
Even so, Mr Munro believes that liquidity will emerge eventually. “These products will develop and thrive because there is strong onus on the investment banks to develop this market. With competition in correlation product already so great and bid/offer [spreads] so much tighter, new products are essential to maintaining and increasing profitability. However, the only way we will ever begin to approximate the narrow bid-offer spreads and liquidity of the interest rate markets with some of these products will be to trade them on standardised index products such as iTraxx,” he says.
Credit spread warrants
Last year, German bank Dresdner Kleinwort Wasserstein (DrKW) came up with the seemingly optimal idea of credit spread warrants. Effectively, they securitise call options on an issuer’s credit and settle in a similar way to bonds. On the date of the warrant’s expiry, investors are eligible to buy a pre-determined amount of newly issued bonds at a pre-agreed price. The advantages to issuers is that they can effectively lock into funding costs at a time when they don’t wish to issue debt, but ahead of possible future issues. For those investors with restrictive mandates that prohibit them from using options or other OTC products, the advantages lie in the securitised form of the products.
In May last year, DrKW launched the first ever such warrants on behalf of French supermarket chain Casino. The following month, it issued 34 tranches of covered-credit spread warrants itself, linked to a range of corporate bond names. Although the products gained some initial traction and Casino appeared happy with its deal, no other players have followed its move.
Even so, Henry Nevstad, managing director and global head of structured debt and private placements at DrKW, is confident that there is good potential for the credit spread warrant market to take off. “As we have already seen in the interdealer market for spread options, people do want to trade the spread in isolation and this provides a simple means of doing so,” he says. “It also complements trading in options on CDS spreads because the underlying of the credit spread warrants are bond spreads.”
Competitive pressure
Another reason for slow take-up could be due to competitive pressures. Almost all the products are associated with one dealer or another. And, although none have stuck proprietary badges on the products, they have tended to ensure that they receive due credit for the products’ invention at an early stage – CMCDSs being the brainchild of Goldman Sachs, recovery swaps that of BNP Paribas (BNPP), equity default swaps from JPMorgan, and so on. Other dealers may be reluctant to see their competitors’ inventions succeed. At least some of the evidence points towards this.
Recovery swaps, which allow investors to bifurcate credit and recovery risk, were first marketed aggressively by BNPP in April last year. Alex Pointier, exotic credit derivatives trader at the bank, says that in the early stages of the product there was plenty of interest and the French bank traded €450m of them in just a few months.
Alex Pointier: recovery swaps activity has slowed
Since then, he says, activity has quietened down a bit. “Some of this is due to disagreements between dealers on the term sheet [which defines the terms of a financial instrument] for this product.
“We had initially proposed a term sheet, but one of the dealers had some alternative ideas and now the dealer community is in the process of deciding on this. When dealers agree on a term sheet, we expect the increased liquidity to help clients focus on this market segment,” he says.
