The market for credit derivatives has exploded, and, as e-trading platforms rush to make execution and settlement more efficient, buy-side firms stand to benefit from a gigantic marketplace that is about to get much easier to access. According to the Bank for International Settlements (BIS), at the end of 2004, the total notional value of credit default swaps (CDSs) was $6.4 trillion. The notional value for the overall credit derivatives market stood at $8.42 trillion in June 2004, having grown 568 percent in three years, according to the BIS and the International Swaps and Derivatives Association (ISDA).
CDSs are bilateral financial contracts in which one counterparty, the protection buyer, pays a periodic fee, typically expressed as a percentage of the notional amount, in return for a contingent payment by the protection seller following a credit event of a reference entity, usually a corporation. Payment is made when an issuer's credit event, such as a bankruptcy, occurs. Defining what constitutes a credit event always has made CDS documentation complex - a fact that, until recently, largely had kept the buy side out of the market.
ISDA produced a standardized confirmation letter in 1992, which was amended in 2002, and made the contract definition of a credit event more precise. Smoothing this documentation process has made trading in CDSs more appealing to hedge funds, which previously had to buy corporate and U.S. Treasury bonds to hedge their risk in purchasing credit derivatives.
"The benefit of CDSs is pretty clear," says Harrell Smith, securities and investments analyst at Celent Communications. "It is a more effective way to take a position on single credit names as well as baskets of securities. The standardization of the contract spurred a lot of interest in the buy side," he adds.
However, the buy side's increased presence in the market has contributed to the unprecedented volume, which, combined with a still-unwieldy settlement process, could mean a serious "traffic jam" and uncertain legal obligations if a major credit event were to occur. The credit derivatives market got a taste of this in April, when ratings agencies downgraded Ford and General Motors credit, and the holdings of hedge funds took a major dive, according to Damon Kovelsky, an analyst with IDC/Financial Insights.
In the dealer-to-customer market, traders mostly construct contracts over the phone and via Bloomberg e-mails, according to Ralph Cioffi, senior managing director in charge of high-grade structured credit strategies at Bear Stearns Asset Management in New York, which manages about $30 billion. Transaction and settlement records are created through a good deal of cutting and pasting of documents, he notes. And confirmations sometimes do not arrive for as long as 90 days, Cioffi says. "When we execute via Bloomberg, we have to notify our back office through an e-mail, we calculate the settlement amount, the dealer sends us the amount and then we notify the buyer or seller of protection, so there are a number of steps," he explains.
Seeing these inefficiencies, regulators, such as the Bank of England, have become concerned about the market's ability to reconcile legal obligations should a major credit event occur. As a result, they have strongly suggested automation. The ISDA, in fact, has mandated the automation of all over-the-counter (OTC) derivatives by 2006.
Zero Tolerance for Delays
Now, there are numerous efforts under way to eliminate the backlogs and reduce settlement times to real time, known as T+0. Creditex, the first electronic dealer-to-dealer platform, launched a new electronic settlement service, T-Zero, on July 28, that is intended to create real-time settlement links with other interdealer-broker platforms, such as those operated by GFI Group, Prebon Yamane and Icap, all of which launched CDS platforms within the last year.
Dealer-to-customer credit trading platform MarketAxess plans to launch CDS index trading this quarter, featuring a link to the Depository Trust and Clearing Corp.'s (DTCC) Deriv/SERV CDS matching service, which launched in 2003 and now has 100 customers, including 80 buy-side firms. Bear Stearns Asset Management is one of the pilot customers of MarketAxess' new service.
"The new MarketAxess platform will eliminate some of the steps we have to go through now," Bear Stearns' Cioffi says. "It really is straight-through processing - we click on [a trade ticket], set up delivery through DTCC, which calculates the settlement payment, then we assign the trade to an account. It can all be done on-screen."
"People use the same settlement methods they used when trades were one-tenth or one-twentieth [the size] of what they are today," notes Barry Goldenberg, credit derivatives product manager, MarketAxess. "The process has started to break down." In addition to trying to ease this congestion by passing post-trade details between trading parties and the DTCC, MarketAxess' service also will perform pre-trade credit checks, heading off potential confusion down the line, according to Goldenberg.
Not to be outdone, dealer-to-customer bond-trading network TradeWeb is launching a CDS platform as well. It is due to go live in the fourth quarter and also will connect with Deriv/SERV. "Cleanup and standardization has solved some of the structural problems of the market," says George Harrington, CDS market manager at TradeWeb. "One of the things the buy side is most excited about is the clarity e-trading brings to the market. In the interdealer space, there are Icap and GFI, who provide liquidity, but those prices are not shared with the buy-side customer, who is excited to get live prices."
Multiple Legs to Stand On
Further upstream in the trading process, order management system (OMS) vendor Charles River Development (CRD), which has supported derivatives such as equity and fixed-income futures and options for years, also has developed multileg CDS functionality. CRD debuted this function in August with the intent of hooking up customers to e-trading networks, which should be ready to interact with CRD by the fourth quarter, according to Rick Enfield, director of product management at CRD. The advantage of multileg functionality is that traders have more flexibility in creating trades around credit issues, he says.
CRD has a template for creating a reference entity - the security upon which the swap will be based - allowing clients to choose, for example, a bond with performance characteristics that resemble those of the issuer that is actually attached to the CDS being bought or sold. "Frequently, clients will use a bond most closely related to the tenor of the swap," Enfield says. "The bond they take may not be the one that's delivered if there is a credit event. We've had a lot of input on this, so it is a fairly rich client implementation."
Henderson Global Investors in London, which has standardized its trading operations on Charles River and manages $120 billion, is scheduled to begin installing the multileg CDS functionality in September across 120 users, relates Andy Jerrom, senior project manager, IT business systems. The OMS will play a vital role in an initiative to clean up operations at Henderson, much as the swaps industry is trying to achieve STP in the greater marketplace, he relates.
"We are trying to achieve full end-to-end automation," Jerrom says. "Hopefully, the trade will get executed, come back through our accounting system and stream back into our portfolio calculation program."
This would be no small achievement. "With these contracts and term sheets attached, there is a plethora of fields," Jerrom continues. "The system has got to be flexible at first, and then standardize over time."
Jerrom expects the implementation to take about six months to percolate into all of Henderson's trader workflows and to synchronize with its back-office facility, which is outsourced to custodian BNP Paribas. The firm already is live in corporate-credit and government-bond dealing on MarketAxess and TradeWeb, but, Jerrom says, he expects it will be a while before the process is seamless across all fixed income, as more-obscure debt has to contend with multiple identification standards and scattered databases.
"I could see [CDSs] going massive - the swap market is bigger than the underlying fixed-income market, and the cheaper execution costs are beneficial for the pension funds," Jerrom says. "Once standardization occurs, [CDSs will be] a commodity that can be readily exchanged. That will make all the difference from a systems perspective."