Three U.S. options and futures exchanges have launched listed products aiming to grab shares of the burgeoning credit-derivatives market, although the new products are facing short-term hurdles and may encounter long-term ones as well.
The most common credit derivatives, typically over-the-counter financial products brokered between counterparties by dealers, are credit default swaps (CDS). They are highly customized and designed to hedge the risks of specific credits and sometimes the indices of credits, including bond issues and commercial loans as well as credit instruments that have been wrapped into securities and sold through vehicles such as collateralized debt obligations (CDOs).
OTC products, especially complex ones, tend to be illiquid and difficult to value, as deterioration in the subprime housing-loan market and in the creditworthiness of securities backed by those loans has recently illustrated. The credit-default products listed over the last few weeks by the Chicago Mercantile Exchange (CME), the Chicago Board Options Exchange (CBOE), and the Chicago Board of Trade (CBOT) are designed to ameliorate those issues by providing ready transparency and, hopefully, plenty of liquidity.
That's a boon to investors, enabling them to buy and sell the products quickly and reduce their risk. The flip side of the coin is that to trade over exchanges, the contracts must be simplified, eliminating much of their currently customized nature in the OTC market. Consequently, investors may find the exchange-listed products less useful, and the dealer community may have less incentive to make markets in what ultimately will be more plain-vanilla and less-profitable financial products.
So far, the exchange listings have not garnered much interest. The CBOT launched its product June 25, and Gene Mueller, managing director of research and development at the exchange, said a week later that, "It's up for trading, and we're not trading yet."
The CME and CBOE have experienced similar slow starts. "So far, in spite of having three different designs [at three exchanges], it's been an uphill process to get the first participants to play the game," said John Nyhoff, director in research and product development at the CME.
The timing of the product launches, however, was less than fortunate. They coincided with the unraveling of Bear Stearns's two large hedge funds investing in subprime-heavy CDOs, and also with concerns about further deterioration in the subprime market. One securitization analyst at a bulge-bracket bank, who was asked to comment on the new credit-default listings, said, "I'm consumed by subprime lending; the world is falling apart," before hanging up the phone.
Ironically, the exchange-listed credit-default products aim to provide more tools to aid investors in their efforts to protect themselves against such adverse credit events. The new listings mimic the intent of OTC CDS, allowing one side of an options or futures contract to purchase credit-risk protection while the other side sells it. The CME and CBOT, both Chicago-based futures exchanges, have based their products on indices of the most liquid, investment-grade credit default swaps, providing investors with the ability to hedge or trade against broad credit-market movements. The CBOE, on the other hand, jumped out of the gate June 19 with credit-default options on five individual companies: General Motors Corp., Ford Motor Co., Lear Corp., Hovnanian Enterprises and Standard Pacific Corp.
Given that the notional principal outstanding volume of CDS grew 33% in the second half of 2006, increasing to $34.5 trillion Dec. 31, 2006 from $26 trillion six months earlier, even a small sliver of that pie should provide the exchanges with plenty of business. The futures-exchange executives reported interest in their products from asset managers, especially large ones such as Pimco, Western Asset and BlackRock that are seeking to hedge broad credit portfolios. Insurance companies and pensions fit into that category as well. They also pointed to hedge funds and more opportunistic asset managers, seeking to make bets on market movements.
More specifically, Mueller said, "There are funds out there that don't have ISDA master agreements in place, and this product would allow them to get exposure in this space without such an agreement." Such agreements, developed by the International Swaps and Derivatives Association (ISDA), provide a template of deal stipulations for users to adhere to. Master agreements already represent a step toward market standardization from privately negotiated deals.
Futures contracts, instead, are guaranteed by the exchanges, and their parameters are generally restricted to price and time, making them much simpler to deal with. In addition, beginning to trade the new instruments will require no operational changes by brokerages or their institutional customers, and there will never be haggling between dealers and counterparties over deal terms, since parties trading over exchanges are anonymous. Rather, a trader enters the credit-default product's specific ticker symbol into the trading workstation he or she already uses and simply punches "enter" to execute.
Nyhoff added that positive investor feedback included the transparency and lesser risk of the CME Credit Index Event contract, which has a five-year maturity and comprises 32 referenced CDS that are reconstituted every six months. "They liked the benefits of an exchange-cleared product, such as the lack of risk concentration compared to a single counterparty [in a CDS]. They also liked mark to market [valuations] on a daily basis, and the simplicity of an exchange contract."
The CBOE's foray into the credit-default market has taken a somewhat different tack. It is awaiting approval to offer baskets of credit-default options, along the lines of the futures products. Currently, however, it is offering options contracts on the five individual names, enabling investors to hedge or trade against widening or narrowing spreads on CDS referencing those companies' credits.
Besides the unfortunate product-launch timing and the usual lag before market participants grow accustomed to new futures and options products, translating complex OTC products into transparent exchange-trade vehicles may face a longer-term hurdle: Some market participants want the complexity of the OTC markets.
At the top of the list of OTC fans are probably today's major dealers, since they can charge a premium for their services and are unlikely to opt for a fraction of the spread revenue by making markets on an exchange. Although the CBOE already had a brokerage lined up to make a market in its credit-default product by the product-launch announcement in early June, the exchanges were still seeking market makers last week. In addition, CDS can be tailored to meet protection sellers' and buyers' specific needs, something that can't be done with an exchange-traded product.
"If I'm used to trading apples with my 12 dealer friends, why would I trade oranges on an exchange where there's no liquidity?" one manager of a credit-investing hedge fund said.
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