In 1965 Gordon Moore, one of the cofounders of Intel, a maker of computer chips, predicted that the number of transistors on a chip would double every two years. He was right; Moore’s Law became gospel, and today there are almost one billion transistors on the chips that run modern PCs.
As far as Credit knows, no one has been brave or foolish enough to make a similar prediction on the size of the credit derivatives market: but since anyone started counting in 1997, the market has increased by around one and a half times each year.
In September three different surveys on the size of the market were released. The most established, that of the British Bankers’ Association, estimated the market would stand at $5 trillion by the end of this year, up from around $3.5 trillion at the end of 2003. And it predicts that the market will continue its rapid growth, increasing a further 63%, to more than $8 trillion by 2006. This would represent a 45-fold increase in the nine years from 1997 to 2006.
A survey of the market by rating agency Fitch finds a slightly smaller market but roughly concurs with the rate of growth. According to Fitch, the derivatives market increased to $2.8 trillion of gross sold outstanding, or $3.0 trillion including cash collateralised debt obligations (CDOs), an increase of 71% from $1.7 trillion last year, or $1.8 trillion including cash CDOs.
The latest survey, done by the International Swaps and Derivatives Association (Isda), is the most bullish both in terms of growth and size. It reported a 44% increase in the size of the market in the first half of 2004 alone, to $5.44 trillion.
As Angela Teke, director of the BBA, says: “Market growth has lived up to expectations, which is a positive sign; there had been some who said the market couldn’t continue to grow at the pace it had been doing.”
It isn’t clear how large the credit derivatives market can grow. It is still slightly smaller than the US and European high-grade and high-yield corporate bond markets, which, according to Lehman Brothers, stand at €6.1 trillion. The interest rate derivative market overshadows the underlying government bond markets by a factor of around 26 times: the latest figures from Isda estimate the rates market at €134 trillion, whereas Lehman puts the US and European government bond markets at around €5.1 trillion.
Coming of age
Ian Linnel, analyst at Fitch, says that the growth in the market belies a more significant change in its nature. “We’ve seen a change in the credit derivative market – similar to what has occurred in other financial markets – from use as a hedging tool to a trading instrument,” he says. Just over half of the banks surveyed by Fitch said that trading was their primary interest in credit derivatives.
The relative size of trading books to hedging books has also changed: a year ago they were around six times larger in nominal terms; now they are nine or 10 times larger. The movement of the banks into credit derivatives as a trading instrument may be noticeable but it is also predictable and follows the cycle of most products. “When we talked to the banks last year they said that they were keen to take credit derivatives slowly until they had assessed the risks involved and had robust risk management and control systems in place,” says Linnel. “Those systems are now in place and activity has been ramped up as a result.”
Hedge fund activity in credit derivatives has grown substantially, according to both surveys. Fitch notes that hedge funds comprise around 20–30% of credit default swap (CDS) volume. Their prominence has potential implications in terms of event risk and price volatility. “Hedge funds can be aggressive and have short time horizons so that will increase volatility,” says Linnel, who attributes some current volatility to hedge funds.
Perhaps more importantly, what happens if the hedge funds move on to another asset class? “They can be quite fickle and liquidity could easily disappear,” he notes. That is also a concern of Andrew Sutherland, manager of Standard Life’s Higher Income fund. “Their involvement is all very well when they are driving spreads tighter as at present but what happens when spreads widen? They will strengthen any trend, positive or negative,” he says.
But hedge funds also bring benefits such as liquidity. Teke notes that hedge funds, which emerged as players on the buy side of the market in the BBA’s previous report, have now become major players on the sell side – representing 15% of the market – and are expected to have a slightly larger share of the market than securities houses by 2006. “Other participants have become increasingly confident in dealing with them,” says Teke, who views the involvement of hedge funds as both buyers and sellers of protection as generally being positive for the market.
According to Fitch’s survey, last year there was a wholesale movement of credit risk out of the banking systems and into the insurance sector with a total flow of around €300 billion – or €370 billion including CDOs. This year that number is up to €460 billion or €545 billion including CDOs.
But this has come about mainly though the activities of one major player: AIG. Without AIG, net flows to the insurance sector have gone down. “The reason is because many insurance companies got burned last year and their appetite has decreased,” says Linnel. “Swiss Re and Chubb have announced in the last year they would either close or scale down their credit derivative activities and focus instead on their traditional products.” Linnel believes that they will come back in the medium term. “The credit derivative market is not that different from the cash bond market: you’re just recreating it synthetically so really it should be part of their core activities,” he says.
In the BBA survey insurance companies’ market share of the protection sellers’ market is expected to rise from 20% in 2003 to 21% in 2006 but Teke agrees that the sector’s activity in this area has calmed in recent years. “The slowing growth of insurance company use of derivatives is partly because in recent years as premiums have gone up the industry has become more profitable, meaning some insurance companies are focusing back on core business,” she says.
According to Teke, asset managers – apart from insurance companies – are still a small part of credit derivatives activity, although there is evidence that this is changing. “Deregulation in Europe, for instance Germany and France, could over the next couple of years spur substantial growth from the sector,” she says.
One of those asset managers currently working through the deregulation process is Roland Muller, portfolio manager at Activest in Munich. “We are currently working on a project to allow us to buy CDS, which we can’t do under current rules,” he says. The investment modernisation law introduced at the beginning of 2004 means that new mandates will be allowed to use CDS. “But at the moment we are going through the process of moving all existing mandates to the new arrangement,” he says. “It’s very time consuming but should be concluded in four to five months. Under the new rules we will only be able to buy protection rather than sell it. Of course, we have operations in Luxembourg that enable us to both buy and sell, but credit derivatives play only a small role.”
UK investors appear cautious when it comes to buying CDS. Graeme Lyness, portfolio manager at Aberdeen Asset Managers, monitors the CDS market as an early warning system for his cash bond portfolio but is not yet a user of the market. “If you take the view that rating agencies are reactive rather than proactive – with which everyone will agree – the CDS market becomes your best view on where the credit market is sitting,” says Lyness. “If you look at the CDS on Sainsbury’s, it gave a big heads-up in terms of spread tightening on the cash bonds.” He does not currently buy protection, although he says that at some point in the medium term, Aberdeen Asset Managers is likely to start buying CDS. “We would be net buyers for hedging reasons only.”
Sutherland at Standard Life says that he expects credit derivatives to become a more important part of his portfolio in the near future. “We are looking to do more in the market as managers and are currently changing the way we operate to enable us to buy CDS,” he says. “We don’t just want to be able to hedge positions but to be able to take short views on names as well.”
Richard Ryan, director of fixed-interest portfolio management at Prudential M&G, says that the acceptance of CDS and other products such as CDOs in the UK market ultimately comes down to a decision by end clients such as pension funds. And while pension trustees have been more adventurous in recent years, there is no imminent prospect of widespread CDS or CDO use in the UK.
The British Bankers’ Association survey identifies indices as the main products for trading and market-making in 2003 by some institutions. The survey predicts that indices will become more important for hedging and active portfolio and asset management by 2006. “Every person we spoke to was positive about the growth in indices,” says Angela Teke, director of the BBA. “The index has improved transparency and demonstrates that this is not an exotic market any more. It’s given everyone more confidence and proves that this is a real market now.” As Andrew Sutherland, manager of the Higher Income fund at Standard Life, says: “Anything that increases liquidity is good.”
Fitch’s survey showed that portfolio products, including the traded indices, grew 49% and totaled $754 billion compared with a 100% increase in single-name CDS trading to $1.9 trillion of gross sold. Nevertheless, despite not being the fastest-growing product in credit derivatives, the role of indices is important. “iTraxx has become accepted rapidly by the market meaning that credit derivatives are no longer seen as a financial weapon of mass destruction but as something that can add liquidity,” says Tim Backshall, director, global credit markets strategy at Barra.
Hubert Le-Liepvre, deputy head of structured credit at SG CIB says that for banks putting together CDOs, iTraxx can be invaluable. “It is attractive as it is easier to trade €50 million or €100 million in a matter of seconds rather than putting together a list of 100 names and hedging one after the other. If you want to sell protection and you can do so at a better price on the index, clearly that makes sense. Then you can adjust the difference on the single-name market.”
Paola Lamedica, senior credit portfolio strategist at BNP Paribas in London, says that the launch of DJ iTraxx indices and leveraged tranches has helped the CDO market to bloom. “These products have introduced liquidity, transparency and standardisation into the CDO market,” she says. “All three aspects are highly appreciated by investors.” However, the huge growth of synthetic CDOs, backed by CDS, does gives Standard Life’s Sutherland cause for concern. “The level of leverage in these products means that the repercussions for the CDS market could be substantial if spreads widen,” he says.
Single-name credit default swaps
With so much focus on index products this year, many market participants predicted that the index business would be the highest growth area, and that standard single-name CDS would pale in comparison. In fact, according to Fitch’s survey, single-name CDS grew by 100% to $1.9 trillion of gross sold.
Angela Teke, director of the British Bankers’ Association, notes that single-name CDS is the bread and butter of the market and that as newer players come into the credit derivatives market, most tend to concentrate on simpler products initially. In addition, the introduction of Isda’s 2003 definitions has been significant in standardising the market and making it more accessible. Already 50–60% of single-name CDS transactions have shifted to Isda 2003.
Another reason for increased CDS activity is greater coverage. “We’re seeing more non-investment grade names and it’s not because of a shift in ratings quality. It’s just that the focus of the market is moving down the credit curve,” says Ian Linnel, analyst at Fitch. The Fitch survey notes that there has been a significant shift away from triple-A exposures, which declined to 17% from 22% last year. Sub-investment grade and unrated exposures represented almost 18% of the surveyed market compared with 8% last year. As a result, the average ratings quality in aggregate this year was mid to low triple-B, compared with low single-A to high triple-B last year.