October 02, 2008

With regulators calling for more oversight of OTC derivatives during the financial crisis, Creditex has quietly launched an electronic delta neutral auction in single name credit default swaps (CDS). The auction is a way to reduce the curve or gap risk that results from contracts expiring and being rolled over into new contracts as they get closer to maturity.

”We have a multilateral matching engine that can find opportunities where they can do these delta neutral switches to reduce their risk,” says Mazy Dar, chief strategy officer at Creditex, the interdealer in New York, which provides operates the leading execution platform for CDS and CDS indexes used by the dealers.

For example, if someone traded a five-year CDS contract and the maturity date is Dec. 20, 2013, the quarterly rolls would be Dec. 20, March 20, June 20 and Sept. 30 each year from the effective date, until Dec. 20, 2013.

If someone sold a lot of protection on the five-year during the week prior to Sept. 20 and someone wants to buy a lot of protection on the five-year the week of Sept. 20, the trades from the prior week mature on Sept. 20 and the trades from the following week will mature on Dec. 20, so there’s a three month gap.

“The way you can reduce that risk is to find someone that has the exact opposing position on their books,” explains Dar. “If you find that counterparty, you can do the delta neutral switch. You are simultaneously buying protection in one-maturity and selling protection in another maturity. That has the effect of reducing risk in both positions,” says Dar.

The new functionality could be of interset to regulators in light of the current financial crisis. Credit derivatives have been blamed for contributing to the failure of Lehman Brothers and AIG, which were counterparties to thousands of CDS positions.

Creditex has been running the delta neutral auctions since May of this year in both the U.S. and Europe. The big problem is finding someone who has the exact opposite positions who wants to trade and figuring out what is the fair price to trade at. Typically a counterparty would go through a broker to find a fair price which can be a time consuming process.