Exchange-Traded Credit Derivatives Poised to Curb Bank Monopoly
By John Glover and Hamish Risk
Dec. 12 (Bloomberg) -- Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. risk losing their hammerlock on the most lucrative financial market when exchanges begin offering credit derivatives next year.
Paris-based Euronext NV, which is being bought by NYSE Group Inc., plans to create contracts based on credit-default swaps, making them cheaper to trade and easier to understand than the derivatives sold by banks. Credit-default swaps, used to speculate on credit quality, also top the product list for Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt- based Eurex AG.
At stake are profits from the fastest growing financial market as exchanges list credit-default swaps alongside stocks, currencies and gold. Deutsche Bank says it earned at least $3 billion from credit derivatives in the first half of this year, about a third of total revenue from financial markets.
``The industry has tried to keep trading among the licensed dealers to limit the erosion of profitability,'' said Satyajit Das, a consultant to banks in Europe and Asia who traded derivatives for Merrill Lynch & Co. and Citibank in the 1980s, and wrote 11 books on the market including ``Traders Guns and Money.'' ``They now see a move to the exchanges as inevitable. The sources of profits will change.''
Divided Market
Ten banks led by Morgan Stanley, Goldman and JPMorgan Chase & Co. in New York, and Frankfurt-based Deutsche Bank, account for 86 percent of trading in credit-default swaps, the fastest growing derivatives, according to Fitch Ratings. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
Exchange-traded credit-default swaps will mean banks having to share fees. The firms will keep to themselves the most lucrative part of the business, building credit derivatives to meet the needs of individual clients, known as structured credit, said Robert Reoch, who made one of the first-ever credit-default swap trades in 1994 while at JPMorgan in London.
Bonuses for bankers who arrange structured credit rose 15 to 20 percent on average this year, beating increases of 10 to 15 percent for credit-default swap traders, according to Michael Karp, head of New York-based executive search and consulting firm Options Group.
Pension Funds
Bankers developed credit-default swaps little more than a decade ago to reduce the risk of defaults by the firms they trade with. Nowadays they're used as an alternative to investing in bonds and about $40 billion of the contracts trade daily, according to Deutsche Bank. The value of outstanding credit- default swaps doubled to $294 billion from $133 billion at the end of 2004, according to the Bank for International Settlements in Basel.
Buyers of credit-default swaps receive the face value of defaulted debt in exchange for the underlying bonds or loans. The cost of the derivatives increases as the perception of credit quality deteriorates and falls as creditworthiness improves.
Listing credit derivatives on exchanges will allow pension and mutual fund managers to buy them. The lack of official prices makes it difficult for fund managers to value the contracts at the end of each day. Pensions, insurers and mutual funds account for less than 15 percent of credit-default swap purchases, according to Lehman Brothers Holdings Inc. data.
``It would be an advantage to use credit-default swaps,'' said Nigel Sillis, who helps manage $17 billion as head of credit research at Baring Asset Management in London. Baring doesn't use the contracts in funds because of restrictions set by investors. ``If they're traded on an exchange it will be easier to convince clients to allow us to use credit-default swaps.''
`Unconscionable' Behavior
Unlike equity or futures markets, credit derivatives have no regulator responsible for monitoring trades. Former U.S. Federal Reserve Chairman Alan Greenspan in May said he was ``appalled'' that people were relying on ``scraps of paper'' to record transactions, an ``unconscionable'' practice that had caused a backlog of unconfirmed contracts.
``The market has suffered from reputational risk due to its opaqueness,'' said Reoch, who now advises banks. ``An exchange- traded product will provide the best point for price discovery. It also has the potential to increase the number of participants dramatically.''
Euronext is working with banks and investors to design contracts that will imitate credit-default swaps based on individual companies and indexes, according to Amanda Sudworth, head of interest-rate products at Euronext.Liffe, the London- based futures trading system operated by Euronext.
``Exchange-traded products will remove counterparty credit risk,'' Sudworth said. ``It will open credit trading as an asset class to everyone.''
Exchange Plans
Frankfurt-based Eurex plans to introduce a futures contract based on an index that tracks 125 companies with investment-grade ratings, known as the iTraxx Europe Index. Eurex, the only exchange to get a license from the 10 banks that own iTraxx, has been working on the plan for more than two years and expects to start offering the products by the end of March, said Candice Adam, a spokeswoman in Frankfurt.
The Chicago Board Options Exchange, the biggest U.S. market for equity and stock-index options, applied to the Securities and Exchange Commission in October to offer contracts on credit- default swaps. The securities will be based on the bonds of five to 10 companies, Joe Levin, the exchange's vice president, said in an interview last month, declining to provide further details.
The Chicago Mercantile Exchange applied to the Commodity Futures Trading Commission in October to provide contracts based on three companies. The market will open in the first quarter, said exchange spokeswoman Pamela Plehn.
Cutting Costs
Exchanges will cut the cost to buy and sell credit-default swaps by eliminating the need for trading agreements with banks and accounting systems that value investments and assess risk, said Mark Watts, global head of fixed income at London-based Morley Fund Management, a unit of Aviva, Britain's biggest insurer.
It costs about 73 cents to trade a futures or options contract on an exchange, and $240 to buy or sell a credit-default swap through a bank, according to data compiled by London-based investment adviser Z/Yen Ltd.
``It's a lengthy process'' to get started in trading credit derivatives, said Watts. ``Exchanges have clearing houses, they have a margins system and investors' back offices are usually linked into them. You've taken a manual process and you've automated it.''
Tried and Failed
Exchanges have failed to lure customers to more complex products, from trading the risk of hurricanes to interest-rate swaps, the biggest derivatives market.
The Chicago Board of Trade has been offering futures on interest-rate swaps for the past five years. Its $8.2 billion of outstanding contracts is dwarfed by $88 trillion of interest-rate swaps traded between banks in the first six months of this year, according to the Bank for International Settlements in Basel, Switzerland.
Eurex planned to begin offering contracts on credit-default swaps by the end of 2005.
``It's open to debate whether an exchange-traded contract would provide any cost savings,'' said Marcus Scheuler, head of integrated credit marketing at Deutsche Bank in London. ``Huge liquidity'' in the market means banks are only making 1 cent on average between prices to buy and sell most credit-default swaps, he said.
Officials for Morgan Stanley, Goldman and JPMorgan declined to comment.
Exchange Hurdles
Banks helped the exchanges overcome one of the biggest obstacles by agreeing in September to allow credit-default swaps to be settled in cash rather than the underlying bonds.
``If an exchange comes up with the mechanics, it at least eliminates counterparty risk,'' said Moorad Choudhry, a visiting professor at London Metropolitan University, who proposed trading credit derivatives on exchanges in a 2002 paper published in the Journal of Derivatives Use, Trading and Regulation. ``It's the neatest way of doing it.''
Investors now have to analyze every contract to make sure they're covered for a default. Eternity Global Master Fund Ltd., a Dallas-based hedge fund, has been seeking payment from JPMorgan since 2002 on a contract based on Argentina's bonds because of a dispute about whether a debt swap constituted a default, according to Jim Renard, a partner at the fund's Dallas-based lawyers Bickle & Brewer.
``We'd like to use credit derivatives more but they're legal contracts and they have to be looked into by legal experts,'' says Mario Hooghiemstra, who helps manage the equivalent of about $9.6 billion at F&C Netherlands in Amsterdam. Most of the funds he manages don't hold credit-default swaps. ``It would definitely help if there were exchange-traded credit-derivative contracts.''
-- With reporting by Shannon D. Harrington. Editor: Serkin (jmp) |
