Settlement biggest CDS market challenge, says Fitch

Prompt and efficient settlement is one of the biggest challenges facing the credit derivatives market, according to a survey published today by Fitch Ratings.

Settlement following a credit event and trade confirmations in general topped the list of concerns from respondents. Pricing and liquidity were also cited as concerns.

“Delphi and Dana highlighted the impact that market technicals related to the settlement of derivatives contracts can have on deliverable pricing when physical settlement is specified and when the amount of CDx notional outstanding dwarfs the amount of deliverables,” said London-based Krishnan Ramadurai, managing director and co-author of the survey report.

Fitch’s fourth annual credit derivatives survey also reported massive growth in the credit derivatives market. In a single year, index and index-related credit derivatives products grew more than 900%, reaching $3.7 trillion, constituting 31% of gross sold positions.

The report shows that while banks continue to shift credit risk to the global insurance and financial guarantor sector, the amount of protection purchased was down significantly at 37%, or $159 billion, from last year. In other words, increasing numbers of banks were beginning to take on credit risk in 2005 via the credit derivatives market. That said, the industry did not move in concert with many large European banks - especially in the UK and Switzerland - which moved from net protection buyers to flat or even net protection sellers. North American institutions were generally stable in terms of their net exposure.

This year the survey and accompanying report includes a forward focus to assess potential future development. Specifically there was little consensus on broad market growth. Growth expectations varied from very robust to moderate or even slow growth. Potential areas for future stagnation included vanilla CDS, CDO-squared transactions and options on CDS, followed by first-to-default baskets.

Index products will continue their massive growth, said respondents. Besides index products, a fair number of investors also expect to see growth in some of the newer structures in the market, including asset-backed CDS, and loan-only CDS.