Frank Monks
For some of the highly traded reference names like Delphi, the US-based auto parts company, it can be as much as 10 times as the related bonds in issue. The notional amount of credit derivatives outstanding on Delphi as it filed for Chapter 11 was in excess of $20 billion, when it only had $2 billion bonds in issue.
The derivatives market continues to grow annually at about 60 per cent despite tight corporate spreads, volatility after Ford/GM downgrades in May and recent concerns about systemic and settlement risks.
Why this growth?
The growth in the last two years has been driven by the risk appetite of private investors and hedge funds searching for higher yields. This came about in an improving climate of creditworthiness with low expectations of defaults, historically low interest rates and high liquidity.
This market has developed far beyond the banking community’s appetite for risk mitigation which kick-started these derivative instruments into life barely 10 years ago. As it evolved through product innovation, through the increased liquidity in the iTraxx & CDX indices and by standardising legal documentation, it attracted risk-takers and traders who see value in the flexibility and leverage such derivatives offer.
Today, investment banks play a far more important role as intermediaries than in their original role as risk shedders. They have heavily invested in risk management and in the marketing of these structures to earn fee income.
Concerns?
The Ford/GM downgrades highlighted the significant role of hedge funds who typically sold protection at the equity tranche levels and bought protection through mezzanine tranches of the indices. This was a positive carry trade with correlation protection…or so it was thought. Instead, it highlighted structural imbalances in the market with unexpected skewed correlation, model risk and the possibility of contagion risk through prime brokers.
This brought back painful memories of the LTCM collapse in 1998 and prompted the New York Fed to reconvene 14 Wall Street banks to discuss hedge fund practices.
So it is hardly surprising that Daniel Broby, CIO of BankInvest, said that ‘the credit default swap market is set to blow up’ as reported in last month’s issue of FINANCE magazine.
However, there are number of differences in today’s market. On the positive side, risk management has improved. Prime brokers and banking intermediaries appear to be far more cautious, controlling counterparty exposures through sophisticated collateral systems and standardised ISDA documentation. Concentration risks are lower and risks are well-spread.
On the other side, there are concerns about where the ultimate risk falls and the expertise of non-banking risk takers. Furthermore and related to these concerns are issues about inside information and conflicts of interest among the larger banks, which have deeper relationships with the corporate reference names than the ultimate risk-takers, who are their clients.
There are also concerns that the continued growth in credit derivatives will pose for cash settlement processes particularly as the standard ISDA documentation often calls for settlement by bond delivery which can distort the bond market in the aftermath of a default. To me, this was brought home by the amount of Credit Event Notices which Nexgen recently despatched and received in relation of the recent Delphi default. It is estimated that there are likely to be more than 10,000 derivative trades referenced to Delphi.
These concerns are compounded by the amount of unconfirmed trades where the average delay is estimated to be 11.6 business days.
In addition, there is a natural ‘doubling-up’ effect in trading credit derivatives, because of their fixed term nature. Acknowledging this, dealer firms periodically agree to bilaterally offset contracts and net exposures to reduce their respective books and ease administrative burdens. A further innovation born from a similar need was the creation of TriOptima, a multilateral swap tear-up service company based in Sweden.
To date, settlement processes in credit derivatives market have not been tested by multiple defaults which one might expect in an economic downturn. The market coped well with Enron in 2001, Worldcom in 2002 and Parmalat in 2003 … but at a time when the market outstandings were considerably smaller. Currently, it is dealing with the large volume of Delphi trades through the ISDA-sponsored Delphi CDS Index Protocol which will set the recovery rate in an auction on November 4th.
Outlook?
Recently, the market was experiencing a mini-boom in recovery swaps on Delphi, driven by structured credit books like that in Nexgen. According to CreditFlux, ‘accumulation of [Delphi] bonds by distressed traders and dealers in anticipation of a contract delivery-led squeeze in the credit derivative market have helped push bond levels into the mid 60s’ from a post-default low in the mid-50s. These levels are believed to be beyond the levels, suggested by fundamental analysis.
The ability of the banking community and hedge funds to weather economic downturns is now dependent on the efficient dispersion of credit risk through the derivatives market. Risk management systems that manage the dynamic nature of correlation and other risks should bear out the faith shown in today’s models.
However, the exponential growth in credit derivatives is causing concern and is forcing innovation in settlement processes.
What exactly the future for credit derivatives will be is difficult to say. There will be problems - multiple defaults, fund closures, litigation etc – which will be met by further innovation in products, secondary market developments, settlement processes, greater transparency and improved risk management.
Contrary to Daniel Broby’s views, I believe that the credit derivatives market will not blow up. It is here to stay and human ingenuity will continue to play a big part in its continued development and self-preservation.