Great expectations

Where are they now?


Twenty years of dynamism in the over-the-counter derivatives market have yielded some astonishing successes. Red-hot competition has fuelled continuous innovation, and created in its wake a phalanx of new derivatives products. Many of them have made an active and visible contribution to the explosive growth of the derivatives market. Credit default swaps (CDSs), for example, came from humble beginnings to constitute a market worth $34.5 trillion in 2006, according to the International Swaps and Derivatives Association.

In the case of the notable successes, it's often difficult to establish who came up with the ideas first, so long is the list of banks claiming responsibility for the product's development. For those ideas that weren't as successful, traders often have suspiciously little to say about their own involvement. These are the products that their creators would rather forget: the 'innovations' that were just a bit too novel, or the 'solutions' looking a little too hard for a problem to solve.

One of the most recent memorable let-downs was the equity default swap (EDS) market. Feted as the equity derivatives world's answer to CDSs, EDSs were designed to take advantage of relative-value opportunities between equity and credit, enabling investors to achieve a higher return than that achievable on a CDS on the same underlying.

EDSs are essentially out-of-the-money barrier options, intended to allow investors to buy and sell protection on a particular company in a similar way to CDSs. The rationale behind the product is that there is a strong correlation between a company defaulting and a substantial drop in its share price. While CDSs are triggered by a credit event, such as bankruptcy or failure to pay, the EDS protection seller pays out if the reference entity's share price falls below a predetermined barrier, usually 30-35% of its initial value.

"When we first marketed the product, the idea was that EDSs in the equity derivatives world would mimic CDSs in the credit derivatives world and would provide higher spreads," says Tolga Uzuner, executive director of absolute value, credit exotics and hybrids at JP Morgan in London.

Credited with the invention of EDSs in 2002 (the first article on the product appeared in the December 2002 of Asia Risk), JP Morgan marketed EDSs aggressively, launching the first rated collateralised debt obligation (CDO) with an EDS component in January 2004. A few other banks followed suit, while interdealer brokerages, such as London-based CreditTrade and Prebon Yamane (now Tullett Prebon), set up screens aimed at servicing the nascent interbank EDS market.

The instrument did have its draws. In an environment where credit spreads were grinding ever tighter - in part driven by a glut of protection sellers - EDSs offered investors higher premiums than those achievable on comparable CDS contracts. In June 2003, Risk reported that EDS spreads on Deutsche Telekom offered a 342% premium compared with the equivalent CDS contract.

But while borrowing heavily from the credit derivatives lexicon, the risks inherent in an EDS are fundamentally different to those of a CDS - for instance, an external shock could cause the entire stock market to fall, hence triggering the EDS barrier, without any one company actually defaulting. This possibility of a market crash scenario made it difficult for a CDO of EDS tranche to obtain an AAA rating.

This may have held back investors, although some claim the combination of equity options with credit derivatives tranching technology meant the product appealed to neither equity derivatives investors (who didn't understand the tranching technology or need to invest in rated instruments) nor credit investors (who were familiar with the technology but didn't want exposure to equities).

Stephane Diederich, London-based head of equity derivatives product management at Credit Suisse, says hedge funds engaged in capital structure arbitrage strategies continue to use EDSs. However, he acknowledges that the instrument has not been as successful as some dealers had initially hoped. "It didn't really take off," he remarks.

But that doesn't mean the product is completely dead. Credit Suisse, for instance, has used EDS technology within structured products - specifically, its collateralised equity and debt obligation (Cedo) transactions. Since its first Cedo deal in May 2005, Credit Suisse has raised $1.2 billion across four transactions, and the bank is currently marketing Cedo V.

Unlike some of the earlier CDO of EDS transactions, Credit Suisse was able to achieve an Aaa rating from Moody's Investors Service, which opened the product up to a broader spectrum of investors, says Diederich.

The bank was able to achieve this by including a so-called insurance portfolio within the transaction. This meant that, instead of taking exposure to a single portfolio of EDSs, the investor is simultaneously short a second basket of names from similar geographical zones and industrial sectors. The idea is that, in a crash scenario, losses in the risk portfolio caused by the underlying EDSs breaching their barriers would be offset by the EDSs in the insurance portfolio, which would come into-the-money as the underlying stocks fall below 35% of their initial value. This additional level of security - combined with the fact that investors are protected if a stock dips below the barrier for the first three years of the product's six-year life - meant the rating agency was comfortable enough to assign an Aaa rating.

"Cedos could be seen as a way to package EDSs in an investor-friendly way, because we sell the structure as a rated bond," explains Diederich.

Others agree the instrument may have a future in structured product form. "Initially, the market tried to take off on its own two feet as a standard product in the absence of the structured product market," says JP Morgan's Uzuner. "But recently, there has been some innovation in the structured product market, from us and our competitors, and that may bring back liquidity into single names."

EDSs might not be entirely finished as a product, but one idea that most in the market agree is dead and buried is bandwidth trading. The market for bandwidth derivatives, which existed between late 1999 and 2002, was intended to make the telecommunications sector more efficient by allowing firms to trade standardised derivatives contracts on their spare wire capacity.

Bandwidth trading was championed by large US energy firms - chiefly Texas-based Enron, which claimed to have traded the first forward bandwidth contract in December 1999. Other energy companies, such as Houston-based El Paso and Reliant, along with US energy brokerages such as Tradition Financial Services (TFS) and Amerex Energy, soon entered the market.

Jeffrey Skilling, Enron's former chief executive - now jailed in Waseca Federal Correctional Institution for conspiracy, fraud and insider trading - declared in 2000 that bandwidth trading would outgrow the interest rate swaps market within five years. Those in the market at the time seemed to find this convincing. "What drew us in was the fact that energy companies were getting involved. When your biggest customers are doing it, you have to pay attention," recounts one former bandwidth broker.

Richard Elliott, London-based co-founder of Band-X, which originally aimed to serve as a market-place for exchange-traded bandwidth contracts, remembers expectations were high. "Things led to huge optimism that was very difficult to counter," he says. At its peak, the industry not only had its own exchange, but its own trading organisation working on contract standardisation, and even its own magazine - Telecoms Capacity, published by the owners of Risk.

Bandwidth trading firms spent billions of dollars building up enormous fibre-optic networks, only to find them practically worthless a few years later. "The speed at which the whole thing imploded was absolutely unprecedented," remembers Elliott, whose firm has now turned to providing outsourced voice services to the telecom sector.

One of the major reasons cited by former market participants for the product's failure was conservatism on the part of large and long-established telecom companies, such as New Jersey-based AT&T and Kansas-based Sprint. The reasoning behind bandwidth trading was to allow firms such as these, which maintained large fibre-optic networks that often went unused, to risk-manage their inventories. "Telecoms networks don't go bad like apples, but they do lose money. Why not sell their spare capacity?" says one former bandwidth broker. But the idea did not catch on among these older industry players, which weren't used to treating cable networks as a tradable and homogenised commodity.

Another notable problem the industry faced was its sheer physical structure. As trading companies and energy firms threw money at the market to build up vast networks, the price of long-haul bandwidth declined sharply. But the local access portion - the 'last mile' of cable at either end - was subject to local monopolies and could not be traded.

"Because of the glut in bandwidth at the time, the value went away from the long-haul portion, such that you would have to have a ridiculously large amount of turnover to justify the cost of the trading operation, the equipment and people," says Elliott of Band-X.

Elliott says he and his partners at Band-X realised the idea was a non-runner very early on. Others weren't so prescient. Many of the companies involved initially threw money into building up unprofitable fibre-optic networks, even as technicians succeeded in packing more and more information into smaller cables. The bursting of the technology bubble ended that.

Given the costs and relative lack of rewards, former bandwidth traders say it is no coincidence that those firms later found to be employing bogus accounting - in particular, Enron and Mississippi-based telecommunications firm WorldCom - were the ones spearheading the market. Many of these companies were also found to be entering into 'hollow swaps' - in other words, selling each other capacity just to generate revenue and booking them as actual sales. But even in its heyday, the market was a loss-maker. Enron Broadband Services, the Texas firm's bandwidth arm, lost almost $500 million in the first three quarters of 2001 alone.

Enron was also responsible for pioneering another popular candidate for entry into the derivatives hall of shame: weather derivatives. The now-bankrupt energy company conducted the first OTC weather derivatives trade with another US energy firm, Koch, in August 1997. But unlike bandwidth trading, the industry has not completely vanished.

The Washington-based Weather Risk Management Association (WRMA) released the results of its annual survey in May, encompassing contracts traded OTC and on the Chicago Mercantile Exchange (CME). "The 2007 annual survey results show clearly that the weather risk industry is here to stay," pronounced Gearoid Lane, the organisation's president.

However, the survey records a sharp decline in the number of contracts traded globally - from just over 1 million in April 2005-March 2006 to 730,087 the following year. The notional value of weather derivatives contracts traded between April 2006 and March 2007 also plummeted, from $45.2 billion in 2005/06 to $19.2 billion. In 2005, the total value of contracts was $8.4 billion, while in 2004, the nominal value of contracts was $4.6 billion.

Temperature remains the most popular type of weather derivatives contract, comprising $18.9 billion of the $19.2 billion notional traded, the survey revealed. Much of the trading occurs on the CME - the Chicago exchange says it traded just under 800,000 weather derivatives contracts in the 2006 calendar year. This exceeds the total reported by WRMA between April 2006 and March 2007 (which includes CME contracts).

Jens Boening, London-based vice-president for commodities and weather origination at Merrill Lynch, who is also vice-president of the WRMA, says the drop in volume is mainly due to hedge funds pursuing less active trading strategies in exchange-traded weather derivatives contracts, and adds that the OTC market's core industrial user base - utilities, energy companies, agriculture and the like - remains largely intact.

Some in the market find this paucity of weather derivatives surprising: weather risk is a very real phenomenon that has a tangible effect on business, they argue. Figures are often bandied around claiming that anything from 70-80% of business revenues may be dictated by meteorology.

On the other hand, the extent of this effect is notoriously difficult to quantify. Boening admits that retailers, clothing manufacturers and drinks manufacturers have trouble gauging the influence of weather on their business. But he cites an almost linear correlation between gas demand and temperature, which means the future for OTC weather derivatives may well lie within the energy sector. Indeed, a number of dealers continue to retain weather trading desks for the purposes of hedging their positions in energy commodities.

Of all the products that now lie upon the derivatives trash heap, one of the constant underlying themes seems to be inflated expectations. "There continues to be a level of activity in weather derivatives. But because the benchmark was so high, they wind up on this list," says North Carolina-based Mark Brickell, who served as Isda chairman between 1988 and 1992 and is now chief executive of electronic OTC derivatives market-place Blackbird. "If you run expectations up too high, you're at greater risk of being perceived as having a flop."

This was particularly visible in bandwidth trading. Sources say the market's development amid the contemporaneous business practices of the US telecoms industry was particularly damaging. Nonetheless, some former bandwidth brokers believe that with a solution for the last-mile problem - and without the pernicious influence of corporations such as Enron - bandwidth trading may well make a comeback. With EDSs, the overbearing triumph of CDSs looks to have contributed visibly to the hype surrounding the market.

"From the beginning, the people involved in this business have been proud to be innovators, so they're always looking for ways to expand the business and do more good for more people," says Brickell. "Sometimes, in the desire to innovate, you go out a little farther than the market is ready to go. But that doesn't mean that the market won't catch up with that idea at some point in the future."

Were ideas such as EDSs, bandwidth trading and weather derivatives a victim of the derivatives market's own runaway success? "For a new product to be liquid and to become mainstream, there has to be a use for it," says Malcolm Basing, chairman of Primus UK in London, and chairman of Isda from 1992-93. "If the product is difficult to hedge, it is going to be more expensive, which limits its use. Some of these things are very sexy when they are first launched, but if they don't actually help the corporate treasurer, what's the point?"

This kind of sentiment echoes that reflected in an article published in Risk in February 1988 titled First Find Your Risk. It documents an apparent trend among risk managers to move away from product-focused orientation and go back to basics, starting with identification of the exposure that needs to be hedged.

Despite this warning, few in the industry doubt that more disappointments will occur. Indeed, some more recent products feature prominently among those suggestions given by the industry for inclusion in the derivatives hall of shame. One London-based interdealer broker moots property derivatives, saying: "If all the publicity were to be believed, this would be expected to have daily trading volumes greater than the US national debt by now."

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