Credit contracts are about to be listed for the first time as exchanges compete for potentially lucrative licensing deals, reports Natasha de Teran.

The fast-growing credit markets have long been on the radar of over-the-counter (OTC) derivatives experts but exchanges are only now preparing to design and list their first contracts.

Despite the escalating levels of competition between derivatives exchanges across the world, and all the excitement and noise that has surrounded the expansion of the credit and credit derivative markets, no exchange has yet listed a credit contract. But this anomaly is set to change in the near future as competing efforts hit the markets. Exchanges from Frankfurt to London and Chicago to Singapore are now hammering out the final details of contract specifications in a bid to secure potentially lucrative licensing deals from credit index providers.

Driven by rivalry

The drive that has gathered force in recent months has been given added momentum by the existence of two rival credit index providers. The Trac-x and iBoxx families of credit default swap (CDS) indices have attracted the interest of exchanges since their launch in mid-2002. The Trac-x family was developed by JP Morgan and Morgan Stanley, who merged their existing families of CDS indices in April last year. The iBoxx group was developed by a rival consortium of banks led by Deutsche Bank, ABN Amro and Citigroup, under the banner of iBoxx, as an independent index provider.

Both indices have been established as viable and attractive trading tools since their debut, and seemingly put paid to the idea that cash-based credit indices would provide the basis for the first listed contracts.

Guido Cortesani, a director in the CDS group at Citigroup, is adamant that a CDS-based solution is optimal. “Cash indices have been widely used for benchmarking. But, because many underlying bond issues they contain are illiquid, they are very difficult to hedge, and therefore trading in cash-index-linked swaps has never really taken off. Conversely, CDS-based indices, just like their underlyings, are fully hedgeable and tradeable, and have rapidly become extremely liquid,” he says.

Lee McGinty, head of credit derivatives strategy at JP Morgan, agrees. “As we have seen, cash-based credit indices do not attract liquidity. They are good and useful benchmarks, but are not suitable for derivatives or trading activity. For that reason, I don’t think that a cash-bond, credit-based future would attract liquidity,” he says.

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Lee McGinty: cash-based credit indices are not suitable for derivatives or trading activity

Tide of opinion turns

The bankers who developed the new indices could be forgiven for blowing their own trumpets. Pavel Pinkava, the manager of interest rate products at Euronext.Liffe, now agrees that a CDS index will work best, even though Liffe, the London-based derivatives exchange, had been looking at developing credit futures for a long time before the arrival of the new indices and had previously studied the possibility of listing futures based on cash underlyings.

Despite his support for the development, he acknowledges the difficulties ahead. “Developed properly, such a contract will offer the first convenient solution to trading credit. That said, a lot of questions still need to be answered in terms of how to get such a contract onto an exchange. Although there are now well-established suites of CDS indices on which to base a future, developing a contract will still be challenging.”

One of the main problems for the exchanges and their eventual partners will be defining the specifications of the contracts: whether it should be cash or physically settled, its maturity, and clearing and settlement details. But the more pressing test for exchanges will also be to ensure that their products appeal to the widest audience possible.

Henry Nevstad, managing director and head of structured debt and private placements at Dresdner Kleinwort Wasserstein, believes that the pure credit solution presented by CDS-based futures will appeal more to dedicated credit investors, the interbank market and hedge funds. In the future, he believes, it could therefore also make sense to introduce bond-based futures, which would essentially be hybrid interest rate and credit contracts. These would have greater appeal to real money investors, he says.

If they are to be widely used, the contracts will have to provide useful hedges for not only the whole spectrum of the credit community but also for loan officers at banks, whose books may differ substantially from investors’ portfolios. Making the products attractive to loan groups will be a vital ingredient in the success of the contracts. Loan officers are increasingly using credit derivatives for two purposes: to estimate the price at which they can extend a loan to a borrower, and to hedge out the loan. They might use the futures contract not only to estimate the price at which they should lend money, but also for hedging the finance. Without their involvement, the new market could struggle to survive.

The bankers behind the two index groups are adamant that their indices have wide appeal. Aurelia Lamorre Cargill, European co-head of interest rate derivative structuring at Deutsche Bank, says that the iBoxx group, which is backed by a community of dealers who sponsor the indices, has drawn wider interest than proprietary cash indices ever did. “The open platform and standardised terms have attracted a wide range of investors. We believe these will be very interested in seeing an iBoxx CDS contract listed.”

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Henry Nevstad: it could make sense to introduce bond-based futures to appeal to real money investors

Transparency and appeal

At Citigroup, which is part of the same consortium, Mr Cortesani believes that to ensure maximum transparency, it will be more important to have a neutral, rules-based approach to the selection of names that are included in an index than to have it mirror a loan or bond portfolio. Although the iBoxx indices are built on a rules-based approach, which restricts the amount of name-picking, he insists that most are of interest for loan books. “We have seen strong interest in the iBoxx products from a wide range of banks’ investors, and even smaller accounts who are turning to these indices to hedge their own residual credit risk,” he says.

On the other side of the fence, Mr McGinty maintains that any contracts based on the Trac-x index will have wide appeal. He says that many bank portfolios regularly use the Trac-x indices for hedging and he estimates that a significant amount of the OTC credit index business is coming from loan books. Although loan officers cannot hedge their portfolios exactly, he believes this is irrelevant.

“You would not be able to match each loan manager’s exposure through an index. Instead, they are able to hedge the market and systemic risk implicitly. They will always have to hedge the idiosyncratic single name risks on a one-to-one basis,” he says.

Even cash bond investors will be able to use the futures as hedges, says Mr McGinty. “Yes, there will be the basis risk between the cash and credit derivative markets, but the trade off for liquidity is that you do not get the exact hedge,” he says.

At Euronext.Liffe, which is so far unaligned with either camp, Mr Pinkava stresses that the integrity and independence of an index’s construction will be the most important element in designing a contract. He believes that the contracts will have to offer a diversified benchmark, aiming to replicate economic or even sector-related risks, but not aim to give exposure to single names or particular interests.

Retail involvement

One group whose interests are not yet being addressed, but which might become an important component in the credit markets, is the retail community. Although retail involvement in the credit markets has been minimal so far, it is likely that it will build up as the markets mature. Retail interests will have to be accommodated, which some say could be difficult given that the first contracts will be based on relatively complex indices of default swaps.

Mr Cortesani disagrees. “It is not true that CDS-based contracts would alienate retail or less sophisticated investors. The CDS product is now well known and a wide variety of users will turn to the products. In any event, the choice we have now is between not having a future or having one that is linked to CDSs,” he says.

Mr Pinkava, whose exchange is likely to be among the first to list the new futures, believes that the retail community would be unlikely to use CDS contracts. Liffe will not be targeting the sector, he says.

Whatever the final design of the contracts, and whatever end-user community they target, the exchanges will still need to obtain the goodwill of the dealers. As Mr McGinty points out, the listed derivatives markets are rife with unsupported contracts and, for successful contracts, exchanges need to ensure they have the buy-in from the dealer community. Securing that, while two rival index groups are supported by competing groups of dealers, could be the most difficult challenge of all for the exchanges.

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