A new standard

It is almost taken for granted that the credit default swap market is set to grow exponentially over the next few years. But as Oliver Holtaway reports, both buyers and sellers of protection admit that certain developments are needed to make such growth a reality

The credit default swap (CDS) market is undeniably booming: since its inception in 1996 it has blossomed to be worth almost $2 trillion. However market participants say CDSs will not attract the diversity of participation seen in the interest rate and currency derivatives markets until they can match the liquidity and transparency of their more mature cousins. Guided by the mantra ‘simplify, simplify’, the CDS market is responding with a raft of measures to standardise contracts and facilitate trading.

At the time of press, the market was still awaiting the release of the International Swaps and Derivatives Association’s (Isda) latest credit derivative definitions – expected since September last year. These definitions aim to clear up several areas of confusion relating to CDSs that have hindered liquidity in the market and deterred potential investors.

The market’s attention has been focused on the restructuring debate. The uncertainty over whether the changing of a loan’s terms – maturity, coupon or amount – should trigger a CDS payout has been a barrier to trade, not only because it puts off potential market entrants, but also because it splits existing participants into two camps: for and against. The restructuring clause is unpopular with sellers of protection such as insurance companies, as the more credit event triggers there are, the more likely they will have to pay out. Conversely, the likelihood of a payout is what makes the clauses popular with buyers of protection.

Doug Kerridge, in Bank of America’s structured products group, insists clarity on the issue will significantly boost investor confidence. “As a dealer, we would prefer a single global standard,” he says. “The present two-tier system, while workable, hampers liquidity, causes some confusion and potentially creates greater documentation risk for market participants.”

On the other side sit participants such as JPMorgan loan portfolio manager Joe Holderness, who argues that at $2 trillion the market’s liquidity would not be dramatically reduced if it were split in two, with one market recognising restructuring as a reason for CDS contracts to be triggered and a second not. In fact this is to some extent already the case. He also disputes that having a split market causes confusion for investors. “While the credit events themselves might need defining, we can live without one global standard where credit events have to be included in a contract,” he says. “Investors and hedgers want CDS exposure to be similar to exposure to the cash market. If you know a name, you should know the jurisdiction that will apply in the case of a bankruptcy, and so which triggers to choose.”

And most anticipate that the restructuring trigger will persist in some form or another. As Bank of America’s Kerridge says: “It will likely remain a part of the credit derivatives market for the foreseeable future because the banks buying protection view restructuring as necessary to hedge their loan portfolios and because regulators currently require it for regulatory capital relief.”

However, while a resolution to the restructuring debate will certainly be welcome, current users of credit derivatives doubt that it will by itself open the floodgates. One head of credit derivatives at a major investment bank believes the restructuring debate is unfairly used by sceptical end users as an excuse to stay away from the CDS market.

Other changes are needed before the market can move from a one-on-one credit insurance market to a commoditised financial instrument.

In January, JPMorgan introduced standard monthly maturity dates in the European market. The move follows the US’s market adoption of standard quarterly maturity dates in November last year. Standard maturity dates have reduced the problem of buying and later selling protection on the same name in order to cancel out a position. Because almost all contracts previously had five-year maturities, an investor buying contracts at different times would be unwillingly exposed to the credit in the period between the first and second contracts expiring.

These standardised dates for maturity will allow investors to use one CDS contract to net out the exposure of another more easily, as rather than trading to contracts of a standard duration (eg, five years), they will trade to contracts fixed to a point in time (eg, February 20, 2008). But while this is clearly a welcome development, not all bankers are convinced. Some believe that the potential for standard maturity dates to improve liquidity in the market has been somewhat over-hyped, and that the market is currently too close to a bespoke trading model for this particular measure to have much of an impact.

Nevertheless everyone agrees on the importance of clarifying the basics. Industry-wide projects such as the Reference Entity Database (RED) are intended to standardise market infrastructure. The Deutsche Bank/UBS Warburg dispute over the bankruptcy of Armstrong World Industries – namely, whether the reference credit was Armstrong World Industries or parent company Armstrong Holdings – illustrated the need for standardised reference data. Led by rivals Goldman Sachs, Deutsche Bank and JPMorgan, Project RED will ensure that both sides of a transaction will know exactly which reference credit they are trading on.

Of course, these developments will mean little if investors (and investment consultants) are not convinced that the standardised market merits their confidence. Chris Francis, head of international credit derivatives research at Merrill Lynch, says that while the market has grown quickly over the last few years, it needs to broaden out and become more mainstream. “Banks dominate the buying and selling. Insurance companies are big net sellers, as are hedge funds; but mainstream investors, the mutual and pension funds, are hardly involved at all. The market will not have reached its full potential until they are using it on a day-to-day basis to maximise returns.”

Mutual and pension funds accounted for 6% of the market in 2002, up from 4% the previous year. That share is predicted to rise as standardisation fosters a simpler, more transparent market, attractive to mainstream investors. Traders already report encouraging signs: large investors are asking far more detailed questions now than they were 12 months ago, and fund managers without the necessary mandates to trade in the CDS market are building expertise by running shadow portfolios.

Standardisation is an essential catalyst to the market’s growth, but everyone accepts that it will take time for mainstream investors to familiarise themselves with credit default swaps. As Francis says: “The CDS market is a bit different from the bond market – the mathematics are counter-intuitive to credit investors. But investors will become comfortable with the market in time.”

If the CDS market is to rival the size and scope of the interest rate or foreign exchange derivative markets, the industry will have make a concerted effort to educate mainstream investors.

e-standard improvements The standardisation effort within the CDS market is not limited to documentation alone. Consolidation in the market’s technological support is also required, and market participants hope that establishing the groundwork of standardised theoretical language will allow information services and trading platforms to improve. Traders still want less effort and more efficiency from technology platforms; while they are not yet calling for electronic trading, they do want a quicker settlement process to ease back office log jams. “We could do with a lot less effort when using electronic matching – the settlements can be a pain,” says JPMorgan loan portfolio manager Joe Holderness. “It would free our people up to do more trading.” It can take up to three days to confirm the documentation on a voice-brokered deal. John McEvoy, founder of online trading platform Creditex, accepts that this is a challenge. “There is industry momentum to speed the settlement process. Traders we speak to complain of a continual backlog from trades – they’d rather spend the time more productively,” he says. An Isda-sponsored initiative to speed up the trading of credit default swaps by standardising the language that computers use to exchange information on contracts is under way. The Financial Products Markup Language (FpML) will allow traders using different software and hardware to execute transactions at the click of a button. Standardised language for credit derivatives will be included in FpML 4.0, to be released this quarter. As FpML is both people- and machine-readable, it should allow the market to move away from manual trading towards live dealing screens. “There is still a way to go with technology platforms and live dealing screens would be an improvement,” says Andrew Whittle, European head of derivatives at Barclays Capital. “It would be helpful in providing price information for other counterparties and end-users.” The market now relies almost entirely on Bloomberg messages – essentially emails sent around touting business. Providers of trading platforms doubt that current demand justifies full electronic trading. “We have electronic trading technology lined up – there just isn’t enough demand at present,” says McEvoy. Technology, he explains, is to some extent ahead of the game, with trading platforms waiting for market entrants. “What the market needs is new participants,” adds McEvoy. “It doesn’t happen overnight, it takes time and education, although a year like 2002 was instructive to many portfolio managers in that it taught them the necessity of actively managing their portfolios.”