Sea change for debt markets
Credit derivatives are set to make the same impact on global capital markets as interest-rate derivatives did when they were first introduced in the early 1980s. Then, as now, market participants benefited from improved liquidity, transparency and accessibility in the cash market directly as a result of developments in the derivative market. The increasingly wide use of credit derivatives suggests that we are in the process of a transformation in credit markets in the same way that use of derivatives transformed interest-rate markets a generation earlier. In this article we highlight the flexibility and liquidity of credit derivatives that is behind this transformation.
An article in the 15 March 2003 issue of The Economist reported that credit derivatives were used by just 0.2% of American banks. This implies that they are not vital or important instruments in the financial markets. In a way, this would be a reasonable conclusion to make. However, while this figure is undoubtedly higher now, its absolute value is not really relevant. The importance of credit derivatives lies in the potential they generate for greater transparency and disintermediation for the market as a whole; transparency with regard to asset valuation; and liquidity and accessibility. Greater transparency and liquidity for just a small percentage of the market – typically the largest banks and securities houses that take on and manage credit risk – works through into better trading conditions for all market participants. This then is the new paradigm shift currently taking place in credit markets, brought about by the isolation of credit as an asset class: greater transparency in evaluating fair value, and increased opportunity to speculate and hedge in credit.
The universe of credit derivatives includes credit default swaps (CDS), total return swaps, credit-linked notes (CLN) and structured credit products such as synthetic structured finance securities. Market notional volumes as a whole, of which the CDS is the most frequently traded, are shown in figure 1. This illustrates the steady rise in use of these products.
Recent occurrences would seem to imply a growing maturity in the credit derivatives market. High profile credit events such as the Parmalat default in 2003 or the Ford and GM downgrades in 2005 have not seen market liquidity dry up; rather the opposite, as dealers sought to make two-way prices continuously available. The revised ISDA definition from 2003 means we have a standard legal agreement to cover all trades, significantly reducing translation risk. And widely available pricing platforms such as those from CreditTrade and Mark-It provide an independent third-party price for investors. All this serves to make the synthetic market more of a driver of the cash market than the other way around – in other words, the ‘tail wagging the dog’ scenario that exists now in interest-rate markets since the introduction of derivatives there.
Greater CDS trading volumes mean that for many corporate reference names there is higher liquidity, and notional outstanding, in the synthetic market than in the cash market1. Under these circumstances it becomes easier to source many US and European credits in the former than in the latter. As CDS prices can be obtained for any maturity, with liquidity generally high along the one, three, five, seven and 10-year part of the curve, we are able to plot a continuous credit curve for many reference names. Thus investors can access in un-funded (CDS) or funded (CLN) form any part of the term structure for the reference name they wish, compared with the more limited access available in the cash bond market. This is illustrated in figure 2.
Investors can trade in the iTraxx index2, which is comprised of 125 of the most liquid CDS names and
provides a benchmark trading level for the market. This improves market accessibility for practitioners because, as in the equity market, it means they have investment options on a standard benchmark. One can enter into curve trades and specific industry sector trades on the Index, as well as single-name versus index trades. The announcement that Eurex and the IIC are developing an exchange-traded credit contract is another parallel with the interest-rate market, where OTC products such as swaps and FRAs were followed by exchange-traded futures contracts.
The market in products such as synthetic collateralised debt obligations (CDO) is well-established. The CDO market has developed into an important sector for issuers and investors alike. However, it is a later development that illustrates the flexibility of credit derivatives to a still greater extent. Recent shortages in supply relative to demand for certain asset-backed security (ABS) notes has resulted in a new market in CDS of ABS. Investors can now access assets such as home equity mortgage-backed securities and credit card ABS in the synthetic market. Investors can also short these assets if they wish, not always possible in the cash market because of the difficulty in borrowing such securities in the repo market.
A basis exists in all markets where cash and derivatives trade; for example there is a crude oil basis as well as a government bond basis. It is simply the difference in price between the cash asset and the price of the asset implied by the futures contract.
The cash-CDS basis in credit reference names is becoming a standard measure of market differential as well as an important measure of relative value in the cash market. This stems from the fact that, according to the no-arbitrage theory of pricing, the premium on a CDS should be equal to an asset-swap written on the same reference name3. In fact for a number of reasons we invariably observe a non-zero basis. The existence of a positive or negative basis provides investors with a measure of relative value; it is also an indicator of potential mis-pricing in either market. This serves to increase market transparency. Investors can analyse the basis across a wide range of corporate and structured finance securities.
From the foregoing we would conclude that the opportunities available in the credit derivatives market provide greater flexibility in strategy and operation for investors, both per se and with regard to the cash market. A liquid market in synthetic assets provides more access to reference names, while a viable index product provides for more effective hedge options. These developments in turn have resulted in greater transparency for the market as a whole, as we can derive a credit curve for almost any reference name across the entire term structure. This all points to a sea-change under way in the way debt markets are valued and analysed, with the improvement in liquidity contributing to efficient markets as a whole.
*Dr Moorad Choudhry is visiting professor at the Department of Economics, London Metropolitan University, and a visiting research fellow at the ICMA Centre, University of Reading. He is author of Structured Credit Products: Credit Derivatives and Synthetic Securitisation (John Wiley 2004), Fixed Income Markets: Instruments, Applications, Mathematics (John Wiley 2004) and The Bond and Money Markets: Strategy, Trading, Analysis (Elsevier 2001). His research can be viewed on www.yieldcurve.com
1Quoted in Lehman International research, September 2005
2Known as CD-X in the North American market. This is managed by the International Index Company Limited (IIC)
3See the author’s paper ‘Some Issues in the Asset-Swap Pricing of Credit Default Swaps’ in Derivatives Week (Euromoney Publications) 2 December 2001 on the reasoning behind the no-arbitrage argument, and his paper ‘The credit default swap basis: analysing the relationship between cash and synthetic markets’ in the Journal of Derivatives Use, Trading and Regulation, Vol 10 Issue 1, June 2004 on the factors that drive the basis