Melvyn Westlake says the legal row between Nomura and CSFB could result in more transparency in the world of credit derivatives.

It may be just another spat between traders of credit derivatives but the outcome of the £1.2m damages suit being brought by Japanese investment bank Nomura against Credit Suisse First Boston could have far-reaching consequences for one of the fastest-growing financial markets.

The point of contention is highly technical. The wider question is whether a bit of fancy footwork on the part of credit-derivative dealers has enabled them to get away with overcharging their hedge-fund clients.

If so, it will confirm many prejudices. To its detractors, the credit-derivatives market is an opaque realm where dangerous tools are promoted by a small cabal of investment banks that deliberately mystify the business in order to rip off unsuspecting investors.

To proponents, credit derivatives are revolutionising credit-risk management. They represent a market of huge potential that has matured rapidly since its beginnings in the mid-1990s, and which is already more transparent than many other markets, including the underlying markets for loans and bonds.

Steps towards transparency

The leading houses designing and trading credit derivatives, such as JP Morgan, Goldman Sachs and Deutsche Bank, are launching a raft of initiatives aimed at making the market more transparent and user-friendly, and preventing the kind of wrangles now engaging Nomura and CSFB; or the dispute 18 months ago between UBS Warburg and Deutsche Bank. Documentation is being streamlined and definitions tightened up.

However, centralised, live, two-way prices - prices available to everybody in the market at the same time and on which traders are committed to deal - remain off the agenda.

Such pricing would be a giant step towards transparency. Dealers insist that although the market is too immature and too complex for this move at the moment, it will come in time. Critics say the dealing houses profit from keeping the pricing of credit-default swaps - the most common form of credit derivatives - opaque and restricting access to their price lists. Dealers are not yet ready to give up the rich trading spreads they enjoy, according to brokers in the market. Credit-default swaps (CDS) are effectively insurance contracts under which one party pays a premium to another in return for protection against the failure of a company to repay its loans or bonds.

The credit-derivatives market, with $1500bn in notional contract amounts outstanding, and increasing by 80% a year, is following a standard pattern. "All financial markets start off as 'niche-y' and obscure. In the second phase, applications are found for the particular financial instruments, and the big banks get involved. This is where we are now with credit derivatives," says Krishna Biltoo, head of product development at the broking firm CreditTrade in London.

"To maintain rapid growth, in the third phase, it becomes necessary to increase transparency. In other markets, one market maker has eventually cracked and provided live, two-way screen prices to everyone. This forces other houses to follow suit. Dealing spreads then contract but the consequent rise in volume more than compensates. This has happened in most markets, for example, spot foreign exchange in the late 1970s," says Mr Biltoo.

In the fourth phase, dealing spreads drop to one or two basis points. The market is completely commoditised, as in wholesale forex and equities. At this point, cost of execution becomes the key issue, he explains.

Says another broker: dealers are "making shedloads of money by setting very wide [bid-offer] prices. They would have to give up these huge dealing spreads in order to make the market really transparent and bring other people in."

Dealers provide prices to brokers on a range of credits (companies with debt outstanding), on which they want to deal. But this is a discretionary, often fairly limited, list. CreditTrade, for example, may aggregate what it calls "benchmark" prices for around 200 credits. These are daily reference prices drawn from real executable prices. Another broker, creditex claims to show "almost 700 'live' prices on its Real Time System, on some days." But dealers admit that they do not always want to "show their hand," or let rivals know their prices. In such cases, the prices are not given to the brokers.

Moreover, those prices that are provided to the brokers are only intended to be shown to the inter-dealer market, not the hedge funds, institutional dealers or corporate treasurers that may be the dealer's own clients.

Although brokers, who in some cases are partly owned by dealers, are reluctant to publicly discuss such restrictions, one says: "The dealers give us their prices safe in the knowledge that they are not going to get a bid from the treasurer of IBM. If that happened, the dealer would not be impressed."

Electronic trading

London-based Joe Santomo, head of credit derivatives at GFInet, the biggest broker in this sector, says: "My customer base is big enough to make it unnecessary to chase the banks' clients. If I did, I would be shooting myself in the foot." Separately, the derivative houses provide prices directly to their own clients. These prices also have restricted circulation. The brokers do not have access to the full client price lists. "It is something I dream about," says Mr Santomo.

Creditex, which was set up in 1999 with ambitions to provide full electronic trading in credit-default swaps to everybody in the market, has been pressed by its dealer customers not to provide its prices to those outside this magic circle, according to one dealer.

Today, creditex collects and distributes price information electronically but matches deals over the telephone in the traditional way. Co-founder Sunil Hirani in New York denies that the failure to implement the original plan is the result of pressure from dealers, several of whom jointly own 50% of creditex, including JP Morgan and Deutsche Bank.

Mr Hirani says there is limited demand in the market for electronic trading, today. The original conception was a little "naove." Infrequent users of the electronic system were accessing the information but providing no business. Now, creditex is geared towards serving the big liquidity providers that give the firm most of its business.

"I don't believe that the banks are all ripping off their customers," says another broker. "But there are certainly opportunities for dealers to go to the wholesale [inter-bank] market and buy a CDS at x price, repackage it, and sell it to a client at two times x."

Information age

Bankers respond indignantly to any suggestion that they charge clients too much. Andrew Palmer, head of North America credit-derivative marketing at JP Morgan in New York, says: "We give more, and better, prices to our clients than we give to other dealers through the broker market"

In addition, fund managers and other institutional investors are often the clients of more than one bank, so they get credit-default-swap prices from several sources, says Stratis Hatzistefanis, co-head of structured credit products at Dresdner Kleinwort Wasserstein in London.

"The overlap is considerable, and there are so many sources of market information today. A few years ago, nobody published prices, even for their own clients," he says.

David Covin, credit-derivatives product manager at Goldman Sachs in New York, says: "What clients really want is the added value that they get from the dealers. The client wants some general idea of the price of the credit. But, most importantly, he wants the story behind the credit, which he gets from a salesperson. He wants to understand what the flows are, what the opportunities are, and what our house view is about the credit."

No comparisons

The fact remains, say critics, that the client does not know what the market-clearing price is for any particular credit in the inter-dealer market and, therefore, has no real comparison when buying default-swap protection from the bank.

Undoubtedly, the market has come a long way very fast. There has been a sharp fall in bid-offer spreads, which are expressed in basis points, or a percentage of the risk spread at which the company's credit is traded in the market (equating to an insurance premium for default protection).

For the top 20 most widely traded credits, the bid-offered spread is probably only five to 10 basis points - for example, a credit might be quoted at 160 to 170 basis points (over the US treasury yield curve). But, on many less liquid credits, the bid-offered spread might be 10% to 20%.

Most traders expect further margin compression and consolidated price lists, possibly even electronic trading, before too long. There have already been some discussions among the leading dealers about posting consolidated prices, according to one senior derivatives trader.

"First, you will see live prices for the most liquid credits put up on screen, for trades of specific amounts and tenors. This list will then be expanded. The end game is for full electronic trading. The technology exists," says London-based Paul Mullin, global head of transactional services at CreditTrade. Dealers acknowledge that future profits are going to come from deploying credit derivatives in structured investment products and various other applications rather than from flow trading, with bid-offered margins falling to one or two basis points in many cases.

Counterparty risk

The most-cited hurdles to this commoditisation of credit-default swaps are counter-party risk and the sheer number of potentially tradable credits. Counter-party risk is important because the seller of protection has a continuing obligation for the life of the contract, which might run for 10 years. This is different to the forex or equity market where the sale of currency or shares is the end of the matter.

As a result, participants in the creditdefault swap market are careful with whom they deal, in order to try to ensure that the counter-party will be able to fulfil their end of the transaction. This complicates any moves to electronic trading.

And, unlike the interest-rate-swap market, the credit-derivatives universe is huge, comprising hundreds and potentially thousands of credits (companies), each multiplied by the number of debts and loans they have outstanding. "We probably have more bonds in the telecoms sector alone than there are currencies in the world," says Mr Covin.

Apart from centralised live screen pricing, a key step for the market will be the development of a credit index that can be traded on the futures exchanges. Although several derivative houses claim to have designed indices, these are based mainly on bond spreads rather than credit-default swaps.

This year, however, JP Morgan has launched what it claims are the first two indices based on actual credit-default swaps - the Hydi (high yield debt index), comprising 100 CDS, referenced to high-yield credits in 20 sectors; and Jeci (JPM European credit index), referenced to 100 of the most liquid credits in Europe.

Contract for CDS

Futures exchanges are keen to develop contracts for credit. When one of them finally does launch such a contract, it could transform the credit derivatives market. "We would expect a futures contract based on a credit index, to have the same effect that the London futures exchange (Liffe) Eurodollar contract had on the interest-rate-swap market, which was to propel it vertically," says Mr Biltoo.

The interest-rate-swap market really took off when the Eurodollar futures contract started actively trading in the 1980s because it ensured that it was always possible to hedge in a hurry, with good underlying liquidity, he says.

Among the welter of initiatives aimed at standardising documentation for credit derivatives, clarifying trading, and providing data and price histories for analytical models, the most important is likely to be Project RED.

This aims to build up a precise database of some 2500 credits, together with the related bonds outstanding, and so eliminate the public disputes that have arisen between derivative houses over exactly which company is the subject of a deal. Companies often have similar sounding names, particularly if they are part of the same group.

If something happens - a company fails to pay its debts or goes bankrupt - the buyer and seller of protection may find themselves disagreeing over the company to which the transaction relates.

One such dispute, which helped to trigger Project RED (Reference Entity Database), arose between UBS Warburg and Deutsche Bank over Armstrong Holdings, and its subsidiary Armstrong World Industries, a US company supplying building materials, including asbestos. In December 2000, the latter company, with most of the outstanding debt, filed for bankruptcy, but the former continued to operate.

Deutsche Bank had sold UBS Warburg protection on one of the two Armstrong companies in a relatively small deal of about $5m or $10m. A disagreement, over which one, was settled out of court.

Getting it right

Companies' situations frequently change. "They merge or de-merge, they change their names, sometimes the debt of one company might be guaranteed by another, the guarantees can lapse or be amended. There are any number of things that can change," says Chul Chung, the business manager for credit derivatives at Goldman Sachs who has been leading the initiative.

There is a huge premium for establishing a market standard to improve the quality of reference data - the right company, the right debt and right relationship between them, he says. "If we do this, it will be good for the industry as a whole and result in a more efficient market."

Law firm Allen & Overy, which has been undertaking the so-called "data scrubbing" will continue to keep the database up to date. The three dealing houses that have been working together on the initiative - Goldman Sachs, Deutsche Bank and JP Morgan - plan to invite other dealing houses to join the initiative.

These three investment banks are also involved in another initiative, together with analytics and data company RiskMetrics, to set up a new, equity-based model known as CreditGrades to assess the credit quality of a large number of publicly listed companies in the US and Europe. Launched in May, CreditGrades is intended to increase transparency and price discovery for a much broader universe of credits than the few hundred so far traded in the CDS market.

Among the main variables included in the model are the equity price of a company, the volatility of the equity price and the amount of debt per share for some 6700 credits. The modellers say there is a strong correlation between equity prices and credit spreads, particularly for the riskier companies.

Until a year or so ago, the market for credit derivatives was strictly focused on investment-grade companies. But there has recently been a big increase in sub-investment grade credits traded, particularly as previously good quality companies have run into trouble, the so-called fallen angels.

"By offering access to this information free on a website, the CreditGrade sponsors are hoping to widen the number of credits traded as well as drawing new types of clients to the market. All these initiatives are lowering the barriers of entry into the credit-derivatives market, says Guy America, co-head of European corporate credit trading at JP Morgan in London. "Lower entry barriers will increase the number of participants. You need to get a lot of people involved in order to improve transparency," he says.

There are also other forces at work. The bankruptcy of Enron, the Houston energy company, and a slew of other corporate governance abuses "has made it untenable for markets to stay opaque," says a New York broker. Derivative markets are going to become more transparent and there is nothing anyone can do to prevent it, he says.


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