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Credit-Index Trading Takes Off

Buy-side interest in two rival credit-derivatives indices is forcing dealers to adopt electronic trading to keep pace.

In the booming business of credit derivatives, hedge funds, insurance companies, asset managers and pension funds have been fueling growth in index trading based on credit-default swaps (CDS).

The surge in buy-side interest - particularly from hedge funds - has led to tighter spreads, more liquidity and growth in CDS index-trading volumes. This, in turn, is causing dealers to seek more automation in terms of electronically trading, booking and confirming the index transactions to scale their operations.

"You've seen an exponential rise in the amount of index trading," comments Samik Chandarana, a vice president at JPMorgan Chase in London who trades the TRAC-X European indices via Creditex, an electronic platform. Comparing the TRAC-X indices to the futures contract on the Standard & Poor's 500 index, Chandarana says, "It's an easy way to take exposure to a well-diversified portfolio from the long or short side."

Index trading has become the hot trend in credit derivatives because it lets investors take a position, such as a negative view of credit, more easily than if they had to short a bond, for instance. "It is one of the driving forces of the industry right now," says Adam Josephson, an analyst at Boston-based Celent Communications who authored a report on credit derivatives in January.

About a year ago, JPMorgan and Morgan Stanley created the TRAC-X index, Josephson writes, "in an effort to build greater transparency, liquidity and acceptance of credit-default swaps." After bickering over the way the index was being administered, the dealers brought in Dow Jones to calculate and publish the index, now known as the Dow Jones TRAC-X. Meanwhile, a separate group of dealers, led by Deutsche Bank, ABN Amro and Citigroup, created the iBoxx index suite.

"These index products were essentially designed to give the buy side broad market exposure to credit risk as an asset class," says Michael Fuhrman, product market specialist at GFI, an inter-dealer broker in credit derivatives.

With TRAC-X, an investor can obtain exposure to the 100 most liquid credit-default swaps in North America, Europe, Asia, Japan and Australia, while iBoxx offers the top 125 names in North America and Europe. Each one breaks down into sub-sectors, such as financials, consumer products, transportation, technology media and telecom, energy, and industrial, so investors can trade different sectors as opposed to the entire index.

Now, the two rival credit-derivatives index products have agreed to merge. According to published reports, the banks have signed a letter of intent to develop a set of indices and create two separate companies covering the U.S. markets, Europe and Asia. Dow Jones reportedly will take over the marketing and licensing of the indices.

"In order to bring this [asset] class to the next level, there will be one [index] family with a consolidated set of rules, and integrated so that it's a global approach," says Lars Hamich, managing director of Frankfurt-based STOXX Limited, which is Dow Jones' index group.

"Index products will be listed on an exchange, and with an exchange listing comes electronic trading," Celent's Josephson says.

The question that arises is, "Will the dealers let the buy-side customers trade directly through an electronic platform?" Right now, the dealers offer proprietary platforms with live prices to their institutional clients. "I have live pricing on-screen during my open hours," says JPMorgan's Chandarana. Though it's not a "quick click-and-trade system," he says, there is only one manual step: clients simply have to call the sales desk to execute the trade at the price displayed on the dealer's screen.

But in the wholesale world, dealers that trade via voice brokers are moving in an electronic direction. In February, Creditex, a small New York City-based brokerage and information provider, re-launched an electronic-trading platform to handle both the TRAC-X and iBoxx indices based on a tradable portfolio of credit-default-swaps on European and U.S. companies. Creditex initially went live in London for European traders and then expanded to North America in March. A source close to Creditex estimates that the electronic platform has captured about 25 percent of the volume in both indices.

"As the volume goes up, you need to have efficiencies in execution and efficiencies in post-trade transaction processes, and the only way you get to do that is via technology," asserts Sunil Hirani, CEO of Creditex.

But this was not the case in 1999, when Creditex first launched the platform for single-name CDS. The market wasn't ready for an electronic trading platform. Instead, Creditex became a voice brokerage, delivering price information through the platform while it drove adoption among dealers. To win the current index business, Creditex cut brokerage fees by 80 percent when it relaunched the e-trading platform in February, a discount that voice brokers had to match, according to several credit-derivatives index traders who use the platform.

"Their system is absolutely phenomenal, and I use it all the time. For indices, they are multiple steps beyond their competition," says a New York-based trader for a U.S. broker-dealer, who requested anonymity.

One of the advantages of the Creditex platform is immediate access to transaction prices. "The electronic-trading platform will tell you at any time what the price is," says a London-based index trader who trades the iBoxx on Creditex. "In voice brokering, you only get to see the best bid and best offer; you're not aware what's behind them in terms of depth-of-market," he adds.

Another value-add is the potential for straight-through processing. Once a trade is completed, Creditex can automate the transfer of the trade from the platform to the dealer's back-office, says Jim Miller, chief technology officer at Creditex. Creditex is using Financial Products Mark-up Language (FPML), a derivatives-industry standard, to connect its system to dealers' back-offices.

Creditex is also working with both the DTCC and Swapswire in Europe, which have built automated matching services for credit derivatives that can flow directly to settlement. Instead of the banks manually comparing the trades, the DTCC does an automated comparison for them, explains Miller.

Competition on the Horizon

While Creditex's Hirani says the adoption of the index-trading platform has exceeded expectations, dealers continue to execute the majority of single-name CDS through traditional voice-brokers such as GFI, ICAP, Tullett Liberty, Tradition and Creditrade (a spin-off of Prebon Yamane).

"[Electronic trading] works very well for the indices which are very straightforward," says the New York-based trader. But he, and others, say it's better to have assistance from voice brokers for single-name CDS, which are less liquid and less standardized.

Though the major IDBs have not yet launched their own screen-based system to counteract the moves by Creditex in the index products, they are expected to do so. ICAP (Garban) is mentioned because it owns the BrokerTec electronic brokering platform. A spokesman for ICAP says the firm believes the liquidity and color that voice-brokering affords is best suited to this product. "We are in a position to give our clients the ability to execute their own trades [in the indices] should the demand arise."

But with the volume growing in the index products and Creditex gaining the upper hand, "Other electronic inter-dealer brokers will have an electronic platform to compete with Creditex," says the New York-based trader. "I'm highly confident we will see two soon," he adds.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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