Coming Attractions: Exchange-traded CDS Indexes
Josh Friedlander ()
February 28, 2005
A futures exchange for credit derivatives indexes is coming, whether brokers like it or not. While some players are dragging their heels, a decision whether to trade the derivatives on a futures market will be made in the next six months. They are now exclusively over the counter instruments.
Major futures markets are pushing for the move, and the leading players in the market, said to be Deutsche Bank, JP Morgan and Morgan Stanley, are expected to benefit from the increases in volume and liquidity that would result from increased transparency and a central clearing process.
But transparency could increase competition and thereby degrade brokers' profit margins, creating opposition especially among the lesser players unlikely to bask in the glow of increased business. Further tightening of already-snug margins would be unwelcome, indeed.
"They might feel that a futures market would bifurcate liquidity [between the exchange-traded derivatives and their own OTC dealings], or maybe they don't want the transparency that this might bring," said Gene Mueller, a managing director of research and development at the Chicago Board of Trade, an exchange eager to host the likely market. He declined to speculate on who the dissenters might be, but he did believe the bigger players would desire a futures market. "The bulk of their profit opportunities lies with the individual issues and not the indices," he noted. Automating index trades could free up employees to concentrate on these more profitable areas.
"Everybody has a different position in the market, and everybody will have a different view based on that position. In the end, we will need to build consensus," said Brad Levy, a vp in the electronic commerce group in the fixed-income, commodities and currencies division of Goldman Sachs. Levy represents Goldman in the firm's role as chairman of the CDS Index Co., a consortium of 16 credit derivatives brokers that trade the Dow Jones credit indices. Dow Jones estimates that their indices now account for 25% of all credit derivative trades conducted via an investable index.
There is a buzz in the air about the concept of a futures market, Levy admits, though he says that CDS Index Co. is not formally investigating the issue at the moment. "The market is thinking about it," he said. "There have been conversations in the market generally, but there has been nothing formal or official that the company is doing." He declined to comment on whether Goldman is in favor of a futures market.
But CDS Index members are informally considering the issue and further action is contemplated within the next six months, assuming that proponents and critics can come to an understanding on how the market will function, said a source familiar with the consortium's deliberations. "Certain dealers have a vested interest in having a launch later than the market would like," the source noted.
Tom Benison, a member of the consortium and a vp in the North American credit trading division at JP Morgan, agreed with Goldman's Levy that the market is abuzz, while noting that the committee is merely contemplating the issue. "We're at a point where the market is gathering information," said Benison. "I think it's fair to say it's a question people have asked. How would it work? What would the impact be? Those are the questions we expect to address."
While the committee may only be contemplating the issue, they won't be able to linger long before tackling it. Demand for a futures market is coming from a vocal and lucrative collection of the consortium's clients: hedge funds.
The continuing expansion of the hedge fund industry, combined with a decrease in convertible bond issuance last year, led many funds to explore capital structure arbitrage, a trading strategy that exploits mispricings between a company's debt and equity, and which almost necessarily requires the use of credit derivatives.
Hedge funds now constitute an estimated 30% to 35% of the credit derivative market, which had been dominated by banks and insurance companies. Unlike these so-called traditional players, hedge funds are not typically looking for long-term relief from risk, seeking instead to make short-term bets, which they could do more expediently on a futures exchange than in over-the-counter trading-or so the argument goes.
The exchanges that stand to benefit from hosting such a market and having credit derivative index volume flow though their trading floors are big proponents. The CBOT and the Chicago Mercantile Exchange have merged their efforts to lobby for the futures business, having agreed to develop, market and host the trading jointly should they be chosen to host the futures. "We've been in contact with various members of the consortium continuing to reinforce our interest. We've been quite transparent in our desire to do this," said the CBOT's Mueller. While Mueller believes there will be progress toward a futures market, he has no idea when the consortium will officially take up the task.
Undergirding this enthusiasm are the Dow Jones indexes themselves, as trading has risen since they were formed last year in a merger of rivals iBoxx Ltd. and TRAC-X LLC. This liquidity has come at a price. Since the merger, bid-offer spreads have decreased from two or more basis points to as little as half a basis point.
JPMorgan's Benison notes that small spreads are an indication that the market is already very transparent. "How can you say it's an opaque market? The bids are tighter than for any of the cash products," he said. "The bid-offer is one-quarter to one-half a basis point." The tightening of spreads to these extremely competitive levels is a point critics may seize upon in opposing the creation of a futures market. But these already small spreads, which have resulted in unprofitable business for some of the smaller players, could be another reason for some brokerages to embrace a futures exchange. "Right now, they've got people making markets in CDS even though they're not really making any money on it," said a source. "They're doing it as a service to their clients, but they'd rather have their people doing something more profitable."