Paralysis has afflicted huge chunks of the financial markets for much of this year. Hardly any collateralised debt obligations (CDOs) have been printed, the residential mortgage-backed securities market has more or less completely jammed up, while the freeze in the leveraged loan market has only recently showed signs of thawing. To the surprise of many, however, particularly those outside the industry, the over-the-counter derivatives market has held up pretty well. In fact, volumes have continued to rise.
According to the latest market survey by the International Swaps and Derivatives Association, the notional amount outstanding of derivatives across asset classes reached $454.5 trillion at the end of 2007, up from $327.4 trillion a year earlier. Among the highlights are credit derivatives, which despite the crisis born out of the subprime space, still managed 81% growth over the year, from $34.5 trillion at the end of 2006 to $62.2 trillion at the end of last year.
Volatility gives rise to trading opportunities - and so, by that reckoning, prop trading desks and hedge funds should be as happy as pigs in mud, slapping on new trades to take advantage of wide spreads. That's undoubtedly happening to some degree. However, numerous bank prop desks have been reducing risk - and staff - in the credit space, while many hedge funds are constrained in the leverage they can take, in some cases making credit derivatives trades, especially on indexes, unattractive.
So, where is all this trading volume coming from? One source is the sheer amount of unwinds and CDO restructurings that have taken place over the past nine months. Some consultancies report being overwhelmed by this type of business since the crisis began - and this is reflected in the current snarl-ups in novations. The novation protocol, published in 2005, dramatically eased the process for the assignment of trades, but the procedure is still conducted through email - and some back offices report being swamped by a stream of new emails on a daily basis. In a report published on April 12, the Financial Stability Forum recommended that the novation process be automated - something the major dealers have taken on board. In their most recent letter to the Federal Reserve Bank of New York, dealers highlighted the automation of novation requests as a key area of focus.
The question is, what happens when the current round of unwinds and restructurings end? If confidence returns, it is possible investors will pour back into the market - after all, people tend to have short memories. But many are likely to remain wary. The bottom line is that much of the trading currently being conducted is unlikely to be repeat business - and if that is the case, the credit derivatives juggernaut could begin to slow.
Nick Sawyer, Editor.