Exchanges eye lucrative credit derivative markets
Thu May 3, 2007 1:29 PM BST
By David Wigan
LONDON (Reuters) - Credit derivatives are not only among the fastest growing markets, but also the most lucrative. Traditionally dominated by banks, the sector faces a shake-up as European and U.S. exchanges try to grab a share of the action.
Eurex, the world's largest derivatives exchange, recently launched credit futures, while Chicago Mercantile Exchange (CME.L: Quote, Profile , Research) is awaiting regulatory approval for credit contracts and NYSE Euronext (NYX.N: Quote, Profile , Research) is planning a credit offering on Euronext Liffe.
At stake is a market that has grown from almost nothing to $35 trillion in six years. It has attracted the attention of regulators and been branded "financial weapons of mass destruction" by investor Warren Buffett, but for the banks at its centre it has proved to be a goldmine.
"The credit derivatives market has been fast growing and provided tremendous profitability to the banking community," said Brad Bailey, senior analyst at Aite Group, an independent research and advisory firm. "There is a natural evolution from over-the-counter to exchange-traded, but there is also a tremendous reluctance by the banks to give it up."
That reluctance has been manifested in the dealer market's apathy toward the first exchange traded credit derivatives to hit the markets.
Eurex futures have been largely neglected by the investment banking community since their launch in March, with only about 400 contracts traded on the investment grade iTraxx Europe index last month.
"Investors are still very cautious," said Heiner Seidel, a spokesman for Deutsche Boerse (DB1Gn.DE: Quote, Profile , Research), which owns Eurex. "People are not jumping in."
Societe Generale (SOGN.PA: Quote, Profile , Research) is the only dealer to say publicly it is willing to make a market in Eurex credit futures. The remainder of the investment banking community has been mute, or even hostile.
"The exchange rhetoric is trying to appeal to your average uninformed individual who might think there is not transparency or liquidity in the over-the-counter market," said the head of credit trading at a Wall Street bank. "They are trying to paint a picture of big bad banks against poor exchanges, which it is rational for them to try to do."
PRODUCTS
Exchanges in any event are ploughing ahead with plans for a host of credit derivative products.
CME securities, originally scheduled to be launched in May but since delayed, will be linked to an index of corporate bonds, and will comprise single name and portfolio default swaps.
The move is part of larger strategy to bring exchange trading to markets that have traditionally traded over the counter, said Rick Redding, the exchange's managing director for products and services. CME last year bought Swapstream, the interest rate swap dealing platform.
"The market is evolving and products are evolving and becoming more commoditised," Redding told Reuters. "As that commoditisation happens it makes sense for the exchanges to become more involved."
What exchanges do well, he said, is to bring more investors into a market and provide cheap collateral management.
CME is also exploring futures based on a Lehman bond index, which will be the first agreements on a broad fixed income index since U.S. regulators gave the go ahead last summer.
There seems at present to be little chance that the bank-owned iTraxx and CDX default swap indexes will be licensed to be traded on exchanges.
The Chicago Board Options Exchange, meanwhile, is awaiting Securities and Exchange Commission approval for options on credit default swaps, a market currently dominated by JP Morgan and Deutsche Bank and others.
While the exchanges may hold out little hope of attracting early investment banking custom, the hedge fund community, with its huge spending power, is a more likely constituency.
"With the amount of hedge fund trading it should be possible to get exchange-traded products off the ground," said Avinash Persaud, chairman of adviser Intelligence Capital. "But banks are high volume traders, so without their participation its not certain how successful the exchanges will be."
Further, it is by no means guaranteed that hedge funds themselves will opt for public exchanges over the private and discrete relationships they enjoy with their bankers.
"The current status quo is efficient as of now," said Graham Neilson, a portfolio manager with hedge fund Credaris. "Ultimately it comes down to liquidity. If liquidity is better on an exchange than over the counter then it will work, but it is a bit of a chicken and egg situation at present." |
