Trading Credit Derivatives: The New Frontier

Former Federal Reserve Chairman Alan Greenspan said in late May, "Credit default swaps [CDSs] are becoming the most important instrument I've seen in decades." He then went on to add that he was "appalled" that people were trading CDSs on the phone and writing down the trades on "scraps" of paper. Furthermore, he stated that current practices in the market were "unconscionable."

The speed at which the credit derivative market has grown has astonished many. In absolute numbers - as well as the myriad of product offerings - it has been met with great reception on many different fronts. The market grew by 106 percent in 2005 with an overall notional amount of $17.1 trillion. CDSs were the fastest-growing component of the overall OTC derivative market of $236 trillion. Many times in recent years, CDS trading has outpaced trading in the underlying bonds.

Filling a Natural Void

The reason for the success of the market is simple: Credit derivatives fill a natural void that existed previously in a company's ability to shift its credit risk. Additionally, they appeal to a wide range of players, ranked in approximate order of activity: dealer's proprietary, loan and correlation groups; hedge funds; asset managers; mutual funds; insurance companies; re-insurance companies; and corporations. As new products are realized, new players are apt to emerge as well, and changes in rankings are to be seen. Hedge funds have dominated the trading of credit derivatives on the client side, representing about 25 percent of CDS trading volume. However, there has been a dramatic increase in interest in these products by traditional asset managers.

Trading in credit derivatives has grown so quickly that it has put unusual stress on the middle and back offices to confirm and process trades effectively. The backlog reached a level last year where both the Federal Reserve and the U.K.'s Financial Service Authority (FSA) commented on possible systemic risk to the financial system as a result of so many unconfirmed and unprocessed trades.

The OTC derivative market is an unregulated market, and, to that end, the Federal Reserve of New York effectively forced 14 of the largest credit derivative dealers into a proverbial room last fall. The dealers included Bank of America, Barclays Capital, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS and Wachovia. Once in the room, the door was locked and no one was allowed to leave until both a framework for reducing the massive backlog of trades and a means to develop a structure for simplifying the processing of credit derivative trades were established.

What arose from those "lock ins" was a comprehensive framework to reduce the ballooning backlog of confirms and settlements. As part of this, there was an agreement to make use of the Depository Trust and Clearing Corp.'s over-the-counter matching service, Deriv/SERV, and move toward a T+5 steady-state affirmation and matching for straight vanilla defaults and indices by October 2006. Lastly, the credit derivative dealers committed to structuring initiatives to increase the utilization of automated matching and processing. However, it became apparent that middle- and back-office technology was not in place to handle the growth in credit derivatives trading.

Drive Toward Automation

Pressure from the Fed and increasing market demands have brought many innovative vendors into the space to try and solve problems related to real-time affirmation and trade automation. This past year has seen a substantial interest on the part of the market to migrate to more electronic trading of credit derivative products, specifically CDSs and indices, as well as an increased drive for automation in the post-trade environment. Moreover, this year also has marked an increased use of electronic trading in the interdealer market, the introduction of index trading in the dealer-to-client space by electronic communication networks (ECNs), the introduction of e-trading of standardized products, new ways of solving some old problems, and a heightened focus on the importance of operations.

Over the next 12 to 18 months, there are several market trends that will emerge in response to the explosive growth of credit derivatives. Technological innovations are the most apparent. Given the expected growth in electronic trading, there are great opportunities for technology providers. The market is young enough to offer innovators a great payoff. Yet it is mature enough to have standards developed for the bulk of the traded credit products as well as diminishing margins to invite technological innovations to increase operational efficiencies.

The industry also should expect to see the evolution of a central clearing house. The DTCC Deriv/SERV is well-positioned to become the de facto clearing house and repository of transactions in the market. Once the utility begins uploading new trades into Deriv/SERV, which is expected in October 2006, and as it develops a framework for handling older trades already in the system, as well as the ability to process payments, the effectiveness of the DTCC in this market will become quite evident.

Since credit derivatives constantly are evolving, new product offerings, especially on asset-backed securities, such as home equity loans and credit card debt, will further increase the torrid growth in this space. It is estimated that the asset-backed securities market is 40 percent larger than the corporate bond market. The fit is so natural for credit derivatives that the uptake in this market is expected to be explosive.

The hybrid trading model also is going to have considerable success and longevity in the credit derivatives market. Although the New York Stock Exchange (NYSE) has made a name for its hybrid trading models, the concept has been well established in the interdealer broker market for a number of years. Going forward, one could see the migration of low-margin, highly liquid products to the electronic brokerage side and the move of high-margin, less-liquid products to the voice brokerage side. As a result, voice brokering is not going anywhere, and with this approach, more of voice brokers' valuable time will be spent on less-liquid names and unusual products, adding value and color, difficult trades, and more-complicated structures to the market.

As electronic markets in indices and single-name credit derivatives continue to gain traction, straight-through processing initiatives will play a vital role as well. Even though e-trading of credit derivatives is not as common in the U.S. as it is in Europe, the pressure from senior management at banks to streamline operational efficiencies will drive this effort. Many of the processes in the CDS market are labor-intensive, and moves to more-automated processes are occurring piece by piece. In fact, IT spending for the processing of CDS trades will out pace spending on front-office systems.

Another area to watch closely is prime brokers in the credit space. This is a relatively new phenomenon as it only started a year ago. But as a part of prime brokers' overall desire to service clients, they are looking at solutions for the processing of CDS trades as well.

The industry is standing at a critical point in the evolution of the credit derivatives market. The driving forces of increased volumes, tighter bid-ask spreads, increased standardization of documentation, innovative technologies and outside pressures all have combined to build the framework for the credit derivatives market of tomorrow, which will be trading in new ways.

Our Analyst

Brad Bailey is a senior analyst at Aite Group, specializing in industrial securities and investments. Having spent more than 10 years working on Wall Street as a sales trader, proprietary equity trader and analyst, Bailey has extensive knowledge of front-end electronic trading of equities and derivatives. He helped Garbon start its derivatives trading desk, and most recently developed and ran a short-term long/short equity trading strategy for six years.