The latest stage in the evolution of the credit derivatives market took place in July with the emergence of standardised first-to-default (FTD) basket swaps.
Until now, FTDs have typically been tailor-made products for taking credit views, with the investor deciding which names should go into the underlying basket. But now, the three banks involved in standardising them, BNP Paribas, JP Morgan and Morgan Stanley, hope their move to commoditise FTD baskets will make the product cheaper while increasing liquidity.
“The purpose of these is to create FTD baskets that are more liquid than customised baskets, and hence open up the asset class to investors who need to have readily observable levels and an ability to exit a product,” says JP Morgan in a research note introducing the product to the market.
FTD basket swaps are a specialised type of basket default swap – a grouping of credit default swaps (CDS) designed to transfer credit risk with respect to multiple reference entities. With FTD baskets, the protection seller is exposed to the first reference entity in the basket for which a credit event occurs.
The price of a FTD basket depends on the price of the underlying CDS and on the implied correlation between the reference credits, which means the product lets investors take a view not only on the default probability of companies but also on the correlation between entities.
Protection sellers typically receive a lower premium for high correlation FTD basket swaps. This is because, if a credit event takes place on one of the underlyings, the probability of the rest of the underlying credits also succumbing to credit events is relatively high, and yet the protection buyer only receives a payout based on the CDS price of the first defaulted company.
In a credit environment characterised by low spreads and low volatility, as investors are faced with at the moment, FTD basket swaps are a relatively simple method of gaining leveraged exposure to credit spreads.
The banks behind the standardised FTD baskets have applied a rules-based approach to creating the baskets, with the intention to remove any subjectivity and give the baskets credibility in the market. In line with Dow Jones’ credit derivatives indexes, there are 11 sector-based baskets with a five-year maturity. There is also a diversified basket containing one name from each of the other sectors apart from the financials and crossover sectors.
The spread information – five-year mid-CDS spreads – used to create the baskets is supplied by independent data company Mark-it Partners. Entities with no spreads are removed, as are the two names with the lowest spread in each sector. The top five names in each sector, in terms of liquidity, are then used to construct each basket.
JP Morgan says it expects the FTD baskets to become instruments that trade from pure market supply and demand rather than from models, as is the case for index tranches. The intention, says the bank, is to supply “a simple, open and transparent model to enable the calculation of implied correlations from the quoted level of spreads”.
“In CDOs [collateralised debt obligations] we have standardised tranches, so people can see where correlation is trading in the tranched space. But now we’re letting investors see what’s happening in the basket space,” says Andrew Palmer, global head of credit derivatives marketing at JP Morgan.
Palmer adds that the product should attract those that until now have not been keen to trade correlation. “Asset managers and some insurance companies have shown hesitation to trade FTD baskets because they can’t see market prices on the products on a regular basis. Now they can. And they can get their books marked by multiple dealers on the same baskets.”
Morgan Stanley says the affiliation of FTD baskets with the Dow Jones suite of indexes, combined with an anticipated increase in the number of dealers trading the product, should serve as a catalyst to boost the trading of FTD baskets to a new level.
“The explosive growth evidenced in tranched synthetic CDOs as a result of their association with the Dow Jones CDX/iTraxx suite of products may be a proxy for the future growth of the FTD market,” says Morgan Stanley in a research note.
In one year, Morgan Stanley’s weekly average volume of US tranched products has increased 11 fold (see figure 1). “The Dow Jones CDX/iTraxx experience has taught us that when many dealers trade a standardised product, liquidity tends to follow,” says Morgan Stanley.
|1. Morgan Stanley US tranched Dow Jones CDX/Trac-X cumulative volume traded|