The World of Credit

The World of CreditA chronology from 1999 to 2008

Contacts

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The world of credit:a chronology from 1999 to 2008Editor Eurex editorial adviser Group editorial director Managing editor Sub-editor Editorial assistant Natasha de Tern Byron Baldwin Claire Manuel Samantha Guerrini Nick Gordon Lauren Rose-Smith Your contacts at Eurex Group art director Art editor Designer Group production director David Cooper Nicky Macro Zac Casey Tim Richards Eurex Zrich AG Group sales director Sales manager Client relations director Andrew Howard Jim Sturrock Natalie Spencer London Office Deputy chief executive Publisher and chief executive Hugh Robinson Alan Spence Byron Baldwin T +44 20 78 62 72 32 [email protected] New York Office Rachna N. Mathur T +1 212 918 48 28 [email protected] Markus-Alexander Flesch T +41 58 854 29 48 [email protected] Eurex Frankfurt AG Peter Noha T +49 69 211 1 47 17 [email protected] Pictures: Alamy, photolibrary, Corbis, Reuters, Getty Repro: ITM Publishing Services Printed by Buxton Press ISBN: 1-905435-58-4

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electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher. The views and opinions expressed by independent authors and contributors in this publication are provided in the writers personal capacities and are their sole responsibility. Their publication does not imply that they represent the views or opinions of Eurex Frankfurt AG or Newsdesk Communications Ltd and must neither be regarded as constituting advice on any matter whatsoever, nor be interpreted as such. The reproduction of advertisements in this publication does not in any way imply endorsement by Eurex Frankfurt AG or Newsdesk Communications Ltd of products or services referred to therein. This publication is published for information purposes only and does not constitute investment advice, respectively it does not constitute an offer, solicitation or recommendation to acquire or dispose of any investment or to engage in any other transaction. iTraxx is a registered trademark of International Index Company Limited (IIC) and has been licensed for use by Eurex. IIC does not approve, endorse or recommend Eurex or iTraxx Europe 5-year Index Futures, iTraxx Europe HiVol 5-year Index Futures or iTraxx Europe Crossover 5-year Index Futures. Eurex is solely responsible for the creation of the Eurex iTraxx Credit Futures contracts, their trading and market surveillance. ISDA neither sponsors nor endorses the products use. ISDA is a registered trademark of the International Swaps and Derivatives Association, Inc.

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Contents

34Contents The World of Credit A chronology from 1999 to 2008

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Contents

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3Forewords 8 The world of credit By Michael Peters, global head of sales, member of the Eurex Executive Board 12 Indexing for growth By David Mark, chief executive, International Index Company 15 Cataloging changes in the credit markets By Natasha De Tern, editor, The World of Credit A chronology from 1999 to 2008 38 The landscape 18 The growth of the credit markets By Hardeep Dhillon 42 The darker side of credit derivatives By John Ferry The upsides By Natasha de Tern Case studies 70 Portfolio overlay strategy using Eurex iTraxx Credit Futures By Byron Baldwin, Eurex 34 28 24 Credit derivatives: the basic instruments, the users and the uses By Hardeep Dhillon Evolution of the credit derivatives market By Hardeep Dhillon 58 iTraxx Indexes the global benchmark for the credit markets By Tobias Sprhnle, International Index Company 63 Eurex iTraxx Credit Futures By Michael Hampden-Turner and Michael Sandigursky, Citigroup The Bloomberg Pricing Model By Mirko Filippi, Bloomberg LP 54 Automation, transparency and the aftermath of regulatory intervention By John Ferry 49 Regulatory intervention By John Ferry

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Contents

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74

Generating alpha trading credit versus equity and equity volatility on exchange By Byron Baldwin, Eurex

97

Using iTraxx across the fund spectrum Natasha de Tern interviews Raphael Robelin from BlueBay Asset Management Plc

118 No free lunch, but a good opportunity to make money By Riccardo Pedrazzo, Banca IMI 122 The use of iTraxx Options in corporate bond portfolios By Stefan Sauerschell, Union Investment 126 Opportunity funds: the thinking investors CDO By Dipankar Shewaram, BlueBay Asset Management 131 The use of iTraxx Indexes in traditional euro corporate portfolios By Martine Wehlen-Bod, UBS Global Asset Management Conclusion 134 Credit derivatives: outlook, challenges and perspectives By Natasha de Tern

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Credit futures: application and strategies By Jochen Felsenheimer, HypoVereinsbank 99 Evaluating opportunities in the credit markets By Chetlur Ragavan, BlackRock 104 Making the most of new credit opportunities John Ferry interviews Graham Neilson from Credaris 107 Using iTraxx in exotic structures Natasha de Tern interviews Ryan Suleimann from Fortis Investments 110 The use of iTraxx in structured credit Natasha de Tern interviews Igor Yalovenko from WestLB 114 CDS and iTraxx: adding to the fixed income managers armory By Maria Ryan, Barclays Global Investors

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Making the case for credit derivatives By Sarah Smart, Standard Life Investments

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A look back at May 2005: Did the models cause the correlation crisis? By Ammar Kherraz, Morgan Stanley Investment Management

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Credit indexes: an efficient route to asset allocation By Gareth Quantrill, Scottish Widows Investment Partnership

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Playing the spread dispersion using index arbitrage By Fabrice Jaudi and Alexandre Stoessel, ADI Alternative Investments

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Foreword

The world of creditBy Michael Peters Global Head of Sales Member of the Eurex Executive Board

I

nnovation and growth in the credit markets have been rampant since credit derivatives first emerged. Many investors have migrated to, or been drawn to, credit and, as a result, the market is now as

sophisticated as any of the longer-standing, larger asset classes. Funds have poured into the sector as investors that previously shunned or ignored the market have waded in. Even those that have remained on the sidelines no longer can ignore it they look closely at movements in the credit area to

Innovation and growth in the credit markets have been rampant since credit derivatives first emerged

Foreword

9

Credit derivatives have experienced explosive growth.The notional volumes of traded credit default swaps had risen from less than USD 1 trillion in 1996 to more than USD 49 trillion by the end of 2006

identify possible trends and imminent shifts that will affect their own markets. As a result, credit derivatives have experienced explosive growth. The notional volumes of traded credit default swaps (CDS) had risen from less than USD 1 trillion in 1996 to more than USD 49 trillion by the end of 2006, according to rating agency Fitch. And there is no evidence that it is slowing down. The credit index market has enjoyed no less spectacular a trajectory: having represented just 9 percent of transaction turnover in 2004, they account today for nearly 50 percent of total volumes. Eurex is privileged to be playing a part in the development of this market and honored to be working with

the International Index Company (IIC), the firm behind the benchmark iTraxx Indexes. In bringing the first-ever listed credit futures contracts to the market, Europes largest derivatives exchange will be working together with the benchmark index provider. The combination is undeniably compelling. The IICs iTraxx rules-based Indexes are the most widely followed, the most objective and the most transparent CDS indexes in the European market. Eurex, meanwhile, offers a broad range of international benchmark products and operates the most liquid fixed income markets in the world, with open, equal, and low-cost electronic access. With market participants con-

nected from 700 locations worldwide, trading volume at Eurex exceeds 1.5 billion contracts a year. The exchange already lists the flagship European fixed income and equity index futures contracts. The EuroBund Futures are the worlds most heavily traded bond futures and the benchmark for the European yield curve. They are often used as the standard reference by those comparing and evaluating interest rates in Europe and managing interest rate risk. On behalf of everyone at Eurex, I hope you will find this publication stimulating and interesting and the new Eurex iTraxx Credit Futures a useful addition to your trading toolbox.

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Foreword

Indexing for growthBy David Mark Chief Executive International Index Company (IIC)

L

ooking back over the emergence of credit as an asset class, it is clear that the pace of development has been meteoric. This holds as true for the sell-sides ingenuity in devising new products

buy-side institutions: the lack of standardization made it difficult to trade the products with anyone other than the issuing bank. The result was the same as it would be for any market lacking standardized index products higher bid/offer spreads and lower volumes. It became increasingly apparent that end customers would be better served by a single, transparent, objective set of market standards. Hosting this at an institution far removed from a single banks trading floor was another imperative. This did not mean limiting the number or type of products, but rather having only a single reference point, such as an industry-wide accepted index. The next steps involved convincing investment banks that, despite having to give up proprietary indexes, they would both be able to retain control through index governance and, ultimately, benefit from that. Fortunately, the banks soon recognized

and structures as it does for investors fastgrown appetite and for the establishment of standardized, widely followed market indexes. The emergence of credit indexes dates back just a few years. It was early 2004; a number of investment banks had packaged some credits and called the result a credit derivatives index. Some had even devised a few basic rules to support their indexes, but the indexes served mainly to provide easy references for baskets of credits. This was convenient for the sell-side, but for obvious reasons it proved difficult for

Foreword

13

It became increasingly apparent that end customers would be better served by a single, transparent, objective set of market standards

this, realizing that they were likely to see greater trading volumes from increased standardization. And so the iTraxx Index idea was born. In the absence of credit derivatives being publicly traded and there being no readily available volume data, it was agreed that the iTraxx Indexes would be investable, reflecting the most liquid traded credits, as measured by data provided by the sell-side. Diversification would be ensured through relevant rules, designed to prevent concentration. Even making allowance for the benign credit environment of recent years, the resulting volumes of index trades (and their share of all credit derivatives trading) have surpassed the most optimistic projections. Such volumes prove that common, transparent, objective standards and readily available data build confidence and can be a huge help in driving the development of newer asset classes. In addition to direct index trades, there has been a proliferation of second and third generation products based on, or referring to,

the iTraxx Indexes. These have been developed by investment banks in response to buy-side needs. As an index company we serve the needs of all market participants and thus continue to see our role as multi-faceted. Naturally, we will continue to update the current iTraxx Indexes and, from time to time when market conditions warrant we will make small changes to the index rules. At all times, such changes will follow close consultation with participants, ensuring that the indexes reflect the markets needs. We will also continue to expand our index family to include other, closely related asset classes for instance, we recently launched the iTraxx LevX Indexes, extending our coverage to leveraged loans. And in the future we will doubtless broaden our geographical reach entering newer or emerging markets, such as the Eastern European or CIS countries. The principles governing iTraxx will, however, remain unchanged: to develop and publish indexes that are independent,

objective, transparent and accessible. As for any new index, the primary goal will always be to ensure that it is driven by the needs of market participants, and becomes the market-leading index in its field. It is only by strictly adhering to these governing rules that iTraxx has succeeded so far and, in particular, achieved its most notable success: broadening credits appeal. While the initial development of credit as an asset class was largely focused on trading between the street and hedge funds, more classical buyside institutions only increased their involvement in the market once the indexes had become more established. The introduction of a wider range of indexbased products, such as the Eurex iTraxx Credit Futures, takes another step in this direction. These futures will doubtless further broaden participation in this asset class by attracting those who do not wish, or do not have the ability, to trade OTC derivatives. IIC is delighted to have worked with Eurex to produce the contracts and wishes the exchange every success with the products.

Foreword

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Cataloging changes in the credit marketsBy Natasha de Tern Editor The World of Credit A chronology from 1999 to 2008

Wbe no exception.

riting about such a fluid and fastmoving subject as the derivatives

fessionals. Movements in the indexes have been widely tracked throughout the last few months, and their progress has been scrutinised and reported on by all sectors of the media. The iTraxx Crossover, HiVol and Main Indexes were referenced no less than 32 times during July 2007 in The Financial Times alone. Market events have also demonstrated just how important a liquid, transparent and tradable benchmark credit instrument is set to become. Credit is now firmly established as an asset class, and credit derivatives and credit index products are the most widely used instruments within the market. An exchange-traded credit futures product, that can be used quickly, efficiently and cheaply, could dramatically improve the market. It could attract new market users and generate even greater trading volumes. Thanks to central counterparty clearing, there is no double credit risk in trading

credit futures, enabling users to discount their worries about counterparty credit risk deterioration, as well as their concerns over increased correlations between counterparty credit risk and underlying credits. Such a facility will always be a bonus, but in times of stress, like those we have recently been witnessing, these considerations come to the fore. Listed credit products, such as the Eurex iTraxx Credit Futures contracts, should also serve to demystify the credit world, increase transparency and allay fears about risk concentrations, over-the-counter trade backlogs and legal documentation issues. Those asset managers, analysts and traders that have kindly contributed to this book have been unambiguous in their regard for these instruments. They welcome the emergence of the first exchange-listed futures products and look forward to using them more extensively and not just in times of stress, but in the daily run of business.

business is rarely if

ever unexciting. But

trying to pin down such an

elusive quarry can be unusually challenging and putting together this book has proved to Between inception and publication, sentiment in the credit markets has shifted dramatically. At the time of writing, it is impossible to determine exactly how matters will play out, but one thing is certain: the events of recent months have underscored not only the central position that the credit industry now holds in the wider financial markets, but also the pivotal role that the iTraxx Indexes now play in the credit markets. The iTraxx Indexes have become such critical market indicators that they are no longer followed just by dedicated credit pro-

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The landscape

The growth of the credit marketsThe development of the credit markets has transformed the European investment landscape. Hardeep Dhillon looks back at the early evolution of the market

The landscape Case studies

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T

he European credit markets have undergone a paradigm shift since the introduction of the euro in 1999. Market participants have now grown accustomed to

remained fragmented, heterogeneous and, because of the numerous currencies involved, they also lacked the depth and breadth of the dollar credit market. The evolution of a pan-European fixed income market was further hindered by corporates borrowing in their local currency, and by national laws that required insurance companies and pension funds to invest large portions of their assets in their local currency. The euro The euro was introduced to world financial markets as an accounting currency on January 1, 1999, and launched as physical coins and banknotes in 2002. It replaced the transitional European Currency Unit (ECU). The arrival of the single European currency lowered the costs of issuing and investing in bonds by eliminating currency risk and reducing transaction costs. It drove supply and demand.

The European bond market, initially dominated by a handful of top-tier banks and financial issuers, has since undergone a remarkable transformation. Today, it encompasses a broader quality range of issuers, and a more eclectic representation of sectors, and has effectively changed Europes currency culture into a credit culture. How has this happened? Well, in part because the trend of decreasing government bond issuance and low interest rates on these transactions forced many more investors to look to corporate bonds for enhanced yield. This provided the impetus for an increased supply of investment-grade bonds with high credit quality and relatively low risk of default and high yield, or so-called junk bonds, which are rated below investment grade at the time of purchase and have a higher risk of default. A shift in behavior away from unprofitable bank financing was a major driver of bond issuance. A similar trend had earlier shaped the U.S. market, where reduced lending

viewing Europes credit market as being much on a par with the U.S. busy, buoyant, liquid and integrated and many may, therefore, fail to recall the state of affairs that existed before the European Economic and Monetary Union (EMU). When the London-based investment bank S.G. Warburg & Co. pioneered the first eurobond back in July 1963, a USD 15 million deal launched by the Italian toll road operator Autostrade, the stage was set for the growth of the European credit markets; but the markets failed to respond. For decades after indeed until EMU they

The arrival of the single European currency lowered the costs of issuing and investing in bonds by eliminating currency risk and reducing transaction costs. It drove supply and demand

margins and a deterioration in the credit quality in bank lending books further encouraged the growth of corporate bonds. An increasing number of U.S. and international issuers that entered the Eurobond market in an attempt to diversify their funding sources engendered further development and variety. Meanwhile, the bursting of the Dotcom bubble in 2000 and the resultant underperformance of stock markets, and the contraction of most European economies, precipitated an auxiliary move by local market participants away from equityfinancing towards bonds. Finally, the raft of high-profile corporate bankruptcies that hit the market around this point not least Enron, Global Crossing and WorldCom

The landscape

21

led banks to tighten their lending policies still further. The European corporate sector facilitated this process of bank disintermediation by loosening its ties with the commercial banking sector and turning to the debt capital markets for direct funding. As a result, the bond market soon came to be regarded as a more efficient and cheaper means of financing than traditional bank lending. Companies quickly recognized that it was much more flexible and did not include many of the restrictive financial covenants of bank loans. This, in turn, led to an increase in the number of one-off borrowers, lesser known and lower-rated companies, that had previously either been restricted to their local currency markets or had been dependent on bank loans. By accessing the bond markets, companies were not only able to diversify their funding sources, but also their creditor base, because bonds were syndicated over many more investors in Europe and abroad. The early years In the aftermath of the euros introduction, there was an initial period of major leveraging by companies. Dominating corporate bond supply were the telecom companies, which piled more debt onto their balance sheets to finance the cost of 3G licences, followed by the auto industry and utility companies. A low interest rate environment enabled the refinancing of transactions at a lower cost, while the pressure on firms to improve returns and shareholder value, and the need to address pension fund shortfalls, were also factors in supporting issuance. The pace of mergers and acquisition (M&A) activity in Europe which was primarily driven by large scale M&A deals in the telecom, bank, industrial and energy sectors, and by leveraged buyouts by private equity firms contributed substantially to keeping the bond market buoyant. Foreign companies also targeted the European market as an alternative source of financing. Those with European businesses were able to capture potentially lower yields in the euro market through transactions that did not have to be swapped back into U.S. dollars. Indeed, ever since Xerox and Gillette launched debut EUR-denominated deals in January 1999, there has been a steady flow of transactions from other North American and international corporates. The increase in market liquidity, and the development of a large and liquid pool of assets, nurtured a growing number of investors at a time when government bond issuance was falling sharply. Investors began to acquire corporate bonds in ever-larger numbers, due to the declining returns on government bonds and a perceived yield pickup over traditional instruments. Another development was the increase in the number of institutional investors that had become comfortable investing in bonds further down the credit quality curve than would have been imaginable even five years ago. Institutional investors still have an overwhelming demand for equities, but the growth in demand from this sector strongly supported the bond markets. To a large extent, this is because some institutional investors, mainly pension funds and insurance companies, have long-term obligations and need to match the tenors of their assets and liabilities a factor that committed them to investing in the corporate bond market.

Dominating corporate bond supply were the telecom companies, which piled more debt onto their balance sheets to finance the cost of 3G licences, followed by the auto industry and utility companies

22

The landscape

The primary and secondary markets Bonds are sold first in the primary market, also known as the new issue market. Here, borrowers, banks and investors come together to launch a transaction through a book building process, which determines the price and level of demand for the bonds. The investment bank, also known as the underwriter or book runner, assists the issuer to structure the bond and prepares the documentation. Depending on the size and structure of the transaction, either a sole underwriter or a syndicate of underwriters can be involved. The underwriter acts as an intermediary, buying the bonds from the issuer and then reselling them to investors. Most of the money received from the sale of the primary issue goes to the issuer. The investment banks earn fees and can make a profit by selling the bonds for more than they paid. It is on the secondary market that bonds are bought and sold following their original sale. This trading is predominantly conducted over-the-counter (OTC), either by telephone or on electronic trading platforms. The secondary market offers investors some flexibility in the pricing and timing of their bond trades, and investors who sell bonds receive the profits, minus any fees or commissions. The issuer of the bonds plays no role in trading on the secondary market, nor receives any proceeds from these transactions. Teething problems In the early years, poor liquidity in the secondary market for corporate bonds was a major constraint on investors involvement, because the trading in many issues was small. Another hindrance was the tendency

of institutional investors to buy and hold bond assets, thereby further dampening both trading activity and liquidity. Certain segments, such as the government bond market, were more liquid and relatively transparent, but the corporate bond segment continued to lack transparency because of the absence of any established central source of independent data and pricing information. Banks were the primary source of information for industrial and lower-rated companies and little attention was paid to the role of credit analysis. Instead, investors simply focused on higher-quality debt. Investment mandates also restricted many from investing in lower-quality, high yield bonds. At this time, obtaining data was often cumbersome and even then it was expensive to access and analyze. The lack of European-

wide regulation or legislation, combined with the relative immaturity of the market, created a number of poor market practices, including the lack of disclosure, timely documentation and adequate covenant protections in bond prospectuses. To add insult to injury, investors could be subject to declines in bond prices and had no way to safeguard against this. Many investors held bonds until maturity, so they would only profit if the assets rose in value. Benefiting from a decline in the price of a bond, or shorting, was difficult because the associated lending fees and transaction costs could render it uneconomic. Finding matching counterparties was also difficult, because the bond market was far less concentrated than the equity markets and, typically, each issuer had several bonds outstanding with different maturities and structures.

The underwriter acts as an intermediary, buying the bonds from the issuer and then reselling them to investors

24

The landscape

Hardeep Dhillon explores the early days of the credit derivatives market the basic instruments, their users and applications

Credit derivatives: the basic instruments, the users and the uses

The landscape Case studies

25

Tinvestor interest.

he arrival on the scene of credit derivatives was to transform the European credit markets radically. The instruments alleviated many of the problems

financing solutions that would provide insurance against the risk that a bond or loan would default. They subsequently began marketing nascent forms of credit derivatives to the wider markets, but it took a number of years before a real market for the products began to emerge. The first deals The U.S. investment bank Merrill Lynch is credited with launching the first credit derivative, a USD 368 million contract, in 1991. And the following year the International Swaps & Derivatives Association (ISDA) first used the term credit derivatives to describe this new, exotic over-the-counter (OTC) contract. Although a number of European banks had been analyzing how to structure contracts, it was another U.S. investment bank, JPMorgan, which first set the European market in motion. Combining derivatives

with credit was still a novel and unproven idea, but in 1994 JPMorgans London derivatives desk structured a first to default swap. It was designed to insure against the default risk of three European government bonds and safeguard the bank against risks in its growing government bond trading business. A further defining moment came in 1997, when JPMorgan launched its Broad Index Secured Trust Offering (Bistro), a transaction that transferred a significant amount of diverse credit risk to an external company or special purpose vehicle (SPV). By employing credit derivatives to offload the risk on a USD 9.7 billion corporate loan portfolio, Bistro helped JPMorgan both to clean up its balance sheet and manage its risk. The bank quickly grasped its wider application and began touting the solution to other firms with ever-increasing success. Credit derivatives steadily gained traction thereafter, as banks derivatives and swaps desks grew ever more involved. By 1995, the market for contracts written on individual companies, or single-name credit default swaps (CDS), was flourishing. It swelled further when more sophisticated fixed income managers started to come into the market in 1997. By this time, there were estimated to be up to 15 dealers that were willing to quote prices in basic instruments in the U.S. market. The old guard of banks JPMorgan, Bankers Trust, Merrill Lynch, Credit Suisse First Boston, Chase Manhattan, Bear Stearns and CIBC Wood Gundy was now being supplemented by newer entrants like Lehman Brothers, Citibank and Bank of Montreal. Despite the heavy involvement of North American banks, by 2000, it was London that emerged as the dominant center in the

discussed in the previous

chapter and fostered a dramatic surge in Credit derivatives emerged from the securitization of mortgaged-backed securities in the 1980s, when credit risk was hedged by transferring the actual assets from the books of bank lenders. The derivatives instruments were first traded sporadically at the end of the 1980s, but it was the 1990s that proved to be decisive for the fledgling market. The pioneers of credit derivatives were those banks prominent among them JPMorgan, Merrill Lynch, Credit Suisse and Bankers Trust that had attempted to devise

Although a number of European banks had been analyzing how to structure contracts, it was another U.S. investment bank, JPMorgan, which first set the European market in motion

26

The landscape

global credit derivatives market. It boasted about ten active Market Markers and a much larger number of banks involved in niche areas, together with the necessary core of non-bank underwriters and interdealer brokers. Pivotal to the growth of the European market was the imminent arrival of the New Basel Accord and its capital adequacy rules. These require banks to apply minimum capital standards and hold a certain level of reserves against assets, and played a fundamental role in forcing banks to improve the risk profile of their balance sheets. Against the backdrop of the incoming regulation, banks saw credit derivatives as powerful tools that could be used to isolate and lay off unwanted credit risks. They realized they could manage their loan and credit portfolios better, if they protected themselves against potential losses by transferring the credit risk to another party, while keeping the loans on their books. The classic role of CDS in the early days was, therefore, to hedge concentrations of risk, improve the diversity of exposure and reduce the amount of capital that banks needed to allocate to their portfolios. Banks also used CDS to reduce credit risk exposure to counterparties, enabling them to continue to offer loans without exceeding internal risk concentration limits. The emergence of credit as an asset class had already highlighted the concomitant hazards: investors appreciated that bonds were far from risk free and were, therefore, attracted to a form of credit protection against so-called event risks. This base of users, meanwhile, grew to include insurance companies, hedge funds, corporates and asset managers. The CDS product Whereas bonds and loans are financial contracts between a borrower and a lender, credit derivatives and specifically CDS contracts are contracts between two counterparties that reference a specific borrower. In essence, the CDS is an OTC insurance policy that transfers the credit risk of a particular corporation or government from one party to another. A standard CDS contract is a privately negotiated bilateral agreement where one party, the protection buyer, pays a periodic fee or premium to another, the protection seller. The contract is designed to cover potential losses that could damage a loan or bond as a result of unforeseen developments, or a credit event (see chart, above). A credit event includes instances where the reference entity on which the contract is written is unable to pay its debts, such as a bankruptcy or restructuring. If a credit event is triggered, then the seller of protection will make a payment to the buyer of the contract. Buying credit protection is equivalent to The early issues Although the credit derivatives market expanded at a record pace, the instruments faced resistance from many quarters and experienced a number of teething problems. Initial concerns related to banks increasing counterparty exposure through their use of credit derivatives, because these contracts were only as robust as the counterparty to the trade. Many potential users and outside observers were wary about the product, noting how it still had to be tested in a serious downturn. Some commentators were particularly scathing. Among other things, credit derivatives were labeled fools gold, and likened to games of Russian roulette: one influential critic, no less than Berkshire Hathaways investment magus, Warren Buffett, went so far as to term them financial weapons of mass destruction. Even the rating agency shorting the credit risk, while selling is termed as going long a reference entity. Source: Brian Eales Study, The Case for Exchange-based Credit Futures Contracts, 2007

The landscape

27

Standard & Poor's is reported to have had its reservations, initially refusing to rate credit derivatives products. One critical element in limiting the expansion of CDS in the early stages was the absence of any broadly accepted and standardized documentation that could clarify the precise terms and conditions of contracts. Liquidity was hampered because the International Swaps and Derivatives Association (ISDA) had yet to finalize documentation for basic credit derivatives structures or for standard definitions of credit events. ISDA had published a standardized letter confirmation allowing dealers to transact under the umbrella of an ISDA Master Agreement in 1991, but it was not until 1999 that formalized guidelines for sovereign and non-sovereign CDS contracts appeared. Prior to this, contracts tended to be negotiated on an ad hoc basis between buyers and sellers of protection. Not only did this routinely delay transactions, but it also opened up the possibility of disputes when credit events occurred. As the Bank of International Settlements (BIS) commented: Risk shedders appear, sometimes, to have been able to exploit the terms of credit derivatives agreements at the expense of risk takers, insofar as payments under CDS contracts are not conditional on actual losses. Another problem concerned the settlement of CDS contracts and the issue of deliverable bonds. In some circumstances, the physical settlement option was not always available since CDS were being used to hedge exposures to assets that were not readily transferable, or to create short positions for users who did not own deliverable obligations. In addition, the absence of insurance-spe-

cific regulations addressing credit derivatives prevented some insurance companies from entering the market. There was also a lack of clarity from regulators as to the impact of credit derivatives on European banks creditrelated capital charges and the levels of capital allocation required on a financial institutions balance sheet against outstanding credit derivatives contracts. One more stumbling block to liquidity was the absence of a balanced two-way market quite simply, there were more hedgers looking to lay off credit risk than there were buying it. As a result, initial deal sizes remained limited to trades in the region of EUR 25 to 50 million. Pricing transactions was also a challenge because there was no industry-standard pricing model for credit. This meant that traders were often obliged to analyze the price of the underlying asset to provide an indication of the levels at which a CDS might be priced or traded. This was somewhat easier to gauge for more liquid bond issues and for frequent borrowers, but the test for many was to price credit derivatives based on debt instruments for which there was little available public information or no credit rating. Finally, risk management tools and quantitative models were still in development, and many firms were in the early stages of implementing credit value-at-risk or other quantitative credit risk management methodologies. The combination of all these factors meant that even though the issues did not actually stall the CDS market, they served to unnerve many of its participants and, in doing so, hampered the develop-ment of next-generation credit products based on CDS.

28

The landscape

Evolution of the credit derivatives marketThe credit derivatives market opened up a plethora of opportunities for investors. Hardeep Dhillon assesses the impact they had on different corners of the credit world

The landscape Case studies

29

WUSD 20 trillion. Index family.

hen the British Bankers Association (BBA)

The legal documentation The publication of the ISDA Standard Agreement in March 1999 was critical in assisting the expansion of the market to a wider investor base. The new Master Agreement was developed in response to disagreements between buyers and sellers in the wake of the 1998 Russian default and, in particular, whether the delay in payments on the City of Moscows debt constituted a credit event. The English courts ruled in favor of the buyers, but doubts remained. In response to ongoing market events, ISDA issued three supplements to the 1999 guidelines within the next two years. These new definitions were soon put to test when, in October 2000, the U.S. life insurer Conseco extended the maturity profile on USD 2.8 billion worth of bonds and loans. Some participants questioned whether such a restructuring should constitute a credit event

because it did not inevitably lead to losses. Others viewed it as being indisputably a negative credit development. ISDA responded in May 2001, with the publication of a Restructuring Supplement that provided counterparties with a selection of four modified restructuring clauses. The issue of successor events came to the fore only a month later, when U.K. utility, National Power, demerged into two companies, thereby creating two successor entities. This resulted in uncertainty over which would be the new reference entity for existing credit default swap (CDS) contracts at the time the ISDA documents only stipulated a successor assuming all or substantially all of the obligations. ISDA subsequently published the Successors and Credit Events Supplement in November, stating that the new reference entity would hold 75 percent or more of the bonds or loans. A dispute between Nomura and Credit Suisse First Boston on deliverable bonds, in the wake of the Railtrack default in October 2001, prompted a further dispute. The U.K. courts eventually ruled in February 2003, that Nomura, the protection buyer, was entitled to deliver Railtrack convertible bonds as physical settlement. ISDA responded by issuing the Convertible, Exchangeable & Accreting Obligations Supplement. An ISDA working group studied the new definitions and the latest version, the 2003 ISDA Credit Derivatives Definitions, came into effect in June that year, incorporating all three supplements. The iTraxx Indexes Secondly, came the indexes. The first tradable credit derivatives index emerged in 2000 when U.S. investment bank JPMorgan

first began collating

statistics on the credit

derivatives market in

1996, volumes totalled

some USD 180 billion. Five

years later, they had grown to USD 1 trillion, and the BBAs most recent forecasts suggest they will accelerate to USD 33 trillion by 2008, up from 2006s figures of The markets rapid growth over the first years of this century as well as its subsequent evolution owes much to two principal factors: the introduction of standardized International Swaps & Derivatives Association (ISDA) documentation and the arrival of the iTraxx

A dispute between Nomura and Credit Suisse First Boston on deliverable bonds, in the wake of the Railtrack default in October 2001, prompted a further dispute

30

The landscape

launched the European Credit Swap Index, quickly followed in 2001 by the High Yield Debt Index, or HYDI, for the high yield market. Morgan Stanleys Synthetic Tracers on U.S. bonds and JPMorgans European Credit Derivatives Index (JECI) and Emerging Markets Derivative Index (EMDI), were launched the following year. Further competition appeared in April 2003, when Morgan Stanley and JPMorgan merged their proprietary indexes to form Trac-x, prompting Deutsche Bank and ABN Amro to launch the iBoxx 100, as a rival competitor for the European market. An American version of iBoxx was launched later in the year, again going head-to-head with Trac-x North America. The indexes gained some traction, but by 2004 participants had become convinced that the establishment of a single, standardized index would better serve the market. That same year, iTraxx was formed out of the merger of iBoxx and Trac-x and constituted the 125 most frequently traded credit default swaps. The markets development It is hard to overplay the effect of these two events on the development of the credit derivatives market. Following the introduction of the standardized documents and indexes, the market raced ahead: not only did volumes in single-name CDS explode, but index trades soared, new users poured into the market and a plethora of new uses was found for the products. Investors already appreciated that credit derivatives could be used for a multitude of different applications the products offered an extremely flexible method of expressing a variety of investment strategies with tailored

sizes, currency denomination and maturities. And because credit derivatives enabled credit risk to be separated from interest rate risk, investors found the instruments could be applied as a substitute for cash bond trades: they did not necessarily need to buy or sell a bond or loan to gain exposure to a desired issuer, nor did there have to be a physical bond outstanding. Early uses of the instruments included hedging individual or single-name credit exposure, or managing the credit risk of a total portfolio. Investors also employed them to increase yield leveraging the value of credit derivatives and undertaking basis strategies to exploit the difference between cash bond and CDS prices. Credit derivatives were further used to separate risks embedded in certain instruments, such as convertible bonds, and to help firms manage their regulatory or economic capital requirements.

The expanding product range It was only after the iTraxx and ISDA initiatives that the credit derivatives product range really began to expand and diversify. And although single-name CDS were for a long time the most common instrument, their dominance has increasingly been challenged by a growing demand for index trades. Indeed, the latest industry survey from rating agency Fitch estimated that the volume of index trades outpaced singlename trades for the first time in 2006. But combining the indexes did not simply enhance liquidity in index-based trades themselves, it enabled a raft of ever more sophisticated products to be developed. Some dealers, for instance, had previously traded tranches based on the indexes between themselves, but it was not until the iTraxx family had been formalized that a standardized market of index tranches

Although single-name CDS were for a long time the most common instrument, their dominance has increasingly been challenged by a growing demand for index trades

The landscape

31

emerged. Dealers began tranching the new iTraxx Indexes almost immediately after their launch. More importantly, they agreed to quote standard tranches on these portfolios, ranging from equity or first loss tranches (03 percent) to the most senior 912 percent tranches. These new tranches not only shared the same underlying portfolios, and the same subordination and thickness, but the documentation supporting the trades was also standardized, as all the Market Makers had agreed to confirm with the same documents. This meant that investors who had traded in a tranche with one dealer could easily mark their positions to market, or unwind their trades with different Market Makers without any transactional risk. Standardized tranching also spawned a host of new products. First-to-default standardized baskets and other tranched index products began to appear in 2004, substantially boosting the transparency and efficiency of trading correlation. Prior to the introduction of standardized iTraxx tranches, correlation desks had, to a large extent, hedged their correlation posi-

tions by generating more client business. Banks could hedge their market risk by using the index, but not the entire correlation risk unless they managed to place the other parts of the capital structure. The iTraxx tranches completely changed this. They permitted banks to create, market and sell single-tranche structures in record time. And at far lower cost than had previously been possible. Credit-linked notes, basket products and credit spread options were the first more structured tools to be used widely, but partially-funded synthetic collateralized debt obligations (CDOs) also rapidly grew in importance. One of the most groundbreaking of the new instruments, synthetic CDOs are collateralized debt obligations that are backed by pools of credit derivatives. The synthetic CDO market soon eclipsed the cash CDO market because of its greater operational simplicity. While tight spreads in the cash market makes it difficult to source underlying assets for traditional CDOs, synthetic CDO transactions avoid this issue and have the flexibility to reference credits from different countries, as well as a range of

credit assets including loans, mortgage- and asset-backed securities, high-yield and emerging market debt. Volumes also quickly grew in equity-linked credit products and swaptions, as well as total return swaps that were developed to sell customized exposures to investors requiring a pick-up in yields on their portfolios. An index option market meanwhile developed alongside, enabling investors to buy or sell a current standard iTraxx CDS at a future date and given price. More recent developments have included the expansion of the iTraxx family. Since it first debuted in 2004, dealers started writing credit derivatives on other debt assets, such as leveraged loans. iTraxx expanded its family in tandem with these developments, launching its LevX Leveraged Loan Index in 2006. CDS have also formed the foundations for two recent structured credit innovations: constant proportion portfolio insurance (CPPI) transactions and constant proportion debt obligations (CPDO). Credit CPPI is a leveraged capital-guaranteed deal that references CDS portfolios and the iTraxx Indexes. There has been a flurry of deals

32

The landscape

since ABN Amro launched Rente Booster, the first credit CPPI deal in 2004. The Dutch investment bank also pioneered CPDOs, which combine CPPI and CDO technology to generate returns of 200 basis points over Libor by dynamically leveraging exposure to a portfolio of CDS. The users As credit derivatives became increasingly standardized, and these new trading and investment tools arrived on the market, they developed into indispensable tools for investing in credit and managing credit risk. Consequently, a larger number of traditional asset managers entered the market. In fact, by 20042005, the range of participants had expanded to include mutual funds, pension funds, corporate treasurers and other investors, all of whom were looking to transfer credit risk, or for extra yield on their investments to compensate for the narrowing returns on conventional corporate and sovereign issues. Banks, hedge funds and securities houses nonetheless remained the biggest buyers of CDS protection, while insurance companies and monolines tended to be protection sellers, absorbing much of the markets credit risk. Within this broad segregation there were further divisions: larger commercial banks tended to be protection buyers, while smaller or regional entities, such as German Landesbanks, were protection sellers. Corporates, government and export credit agencies were net buyers, while pension funds and mutual funds were net sellers. Corporates, meanwhile, began to use CDS to insure themselves against credit exposures with risky commercial counterparties, such as customers or suppliers. The infrastructure The development of the market infrastructure gathered momentum as the market took off. The interdealer trading firm Creditex, for instance, launched the first electronic platform for trading index-based credit derivatives in 2004. The emergence of this, and other subsequent dealer-to-dealer electronic platforms, facilitated greater transparency and turnover in the interdealer market, speeding up price dissemination and market efficiency, thereby enhancing transparency and liquidity, and making trading easier for dealers. This evolution highlighted the need for independent pricing and valuation services and less reliance on pricing based on dealers proprietary models. As a result, and in a matter of just a few years, a dealer-owned firm, Markit, emerged as the benchmark provider of independent data and portfolio valuations of credit derivatives. A raft of other providers also entered the market, providing additional data sources, such as Interactive Data, SuperDerivatives, Numerix, Barra Credit and Credit Market Analysis. The client or dealer-to-customer side of the market did not, however, evolve so rapidly. While a growing proportion of dealer-to-dealer trades were conducted electronically, the few initiatives launched to serve the client side of the market failed to gain traction. Thus, the transparency, liquidity and operational benefits of the electronic markets were largely the preserve of the giant dealer firms. Nonetheless, the consensus at this time was that the growing importance of CDS, the exponential increase in volumes and improving liquidity would continue apace, while an ever-expanding pool of investors would further enhance liquidity.

Banks, hedge funds and securities houses nonetheless remained the biggest buyers of CDS protection, while insurance companies and monolines tended to be protection sellers, absorbing much of the markets credit risk

34

The landscape

iTraxx Indexes the global benchmark for the credit marketsStandardized credit indexes are the backbone of the credit markets. Tobias Sprhnle, from International Index Company (IIC), details how the indexes are constructed and explains how they are used

I

n recent years, the credit default swap market has experienced exponential growth. A major driver behind this has been the development of a transparent index market. Standardized credit default

The present Credit has become a recognized asset class and a source of risk. Most market participants have some form of credit exposure that needs to be managed, measured and priced, and first generation credit derivative instruments enabled investors to do this, as well as to trade this risk separately from interest rate and/or currency risk. The first-generation products were quickly embraced by the market and, as a result, the credit derivatives market grew rapidly in its early years but it was only with the creation of the first standardized indexes, the iTraxx family, that the market really began to take off. The International Index Company (IIC) manages and administers the iTraxx Indexes and sets the market standards for investing, trading and hedging the iTraxx Index family. With the iTraxx families, IIC not only covers the European and Asia/Pacific CDS markets,

where it has rapidly become the benchmark, but it also recently debuted in the European leveraged loan CDS market with its iTraxx LevX Indexes. As an independent index supplier, IIC is committed to open and transparent markets. Setting the market standard to facilitate investment, trading, hedging in the indexes and helping to improve market liquidity in tradable iTraxx CDS Indexes, is an important part of IICs business rationale. Its indexes are objective, rules-based and dependable, and adhere to the highest quality standards. As a result of the growing standardization brought to the market by IIC, index volumes have grown rapidly in recent years. The British Bankers Association (BBA) estimated that index trading had become the second largest segment of the credit derivatives market by the end of 2005. The London-based association estimated that it accounted for some 30 percent of total

swap (CDS) indexes revolutionized

corporate credit trading, opening

the door to greater liquidity and transparency, attracting new investors and creating important standardized vehicles for the structured credit markets. Credit indexes are easy and efficient to

trade. Investors can use them to trade credit risk separately from interest rate and/or currency risk, to express bullish or bearish views on credit as an asset class and to actively manage investment portfolios all the while benefiting from the low transaction costs associated with static portfolios.

The landscape

35

Comprehensive European platformBenchmark indexes iTraxx EuropeTop 125 names in terms of CDS volume traded in the six months prior to the roll

Sector indexes Non-Financials100 entities

Standard maturities iTraxx Europe, HiVol3 5 7 10

iTraxx Europe HiVolTop 30 highest spread names from iTraxx Europe

Financials Senior25 entities

iTraxx Crossover5 and 10

iTraxx Europe Crossover Financials SubExposure to 50 European sub-investment grade reference entities

iTraxx Sector Indexes25 entities 5 and 10

First to Default baskests:Autos, Consumer, Energy, Financial (sen/sub), Industrials, TMT, HiVol, Crossover, Diversified Source: IIC

volumes, only marginally less than the 33 percent share of single-name credit default swaps. A more recent survey by the rating agency Fitch has revealed that index trades have since outpaced single-name trades. Fitch estimates that index trades accounted for some 44 percent of volumes at the end of 2006, compared to the 40 percent of total volumes driven by single-name CDS. The purpose Investors can use iTraxx CDS Indexes to trade large positions in credit names without having to take on direct exposure to the underlying securities, and managers can use the indexes to manage the three separate

components of their portfolios: credit risk, interest rate duration and relative value. But the instruments also provide trading opportunities for other participants, such as speculators and arbitrageurs. For instance, taking a short credit position in the iTraxx Europe (the main index of 125 equallyweighted investment grade names) without exposure to a cash bond position, offers upside potential in the case of underlying credit deterioration. Arbitrageurs can also use the indexes to exploit spread differentials between the CDS, equity and cash markets. The additional liquidity provided by trading desks, hedge funds and arbitrageurs undertaking these strategies has greatly

influenced the index market, making it more liquid and thus an easier and more efficient means of gaining risk diversification and market exposure. Since the iTraxx Indexes were introduced, the basis between EUR-denominated cash bonds and CDS has been greatly reduced. This is because trading desks have increased their trading activity substantially, and hedge funds seeking to profit from price inefficiencies between the CDS and cash bond markets have helped to tighten the cash/synthetic gap. As the index market has developed and expanded, and liquidity in credit has improved, it has become possible to trade

36

The landscape

tighter ranges and higher volumes, and to enter and exit relative value and curve trades at lower cost. The liquidity and transparency provided by the indexes has paved the way for new products, such as standardized firstto-default baskets, sector indexes and iTraxx tranches. Short-biased managers and momentum traders are now able to put on volatility trades in sub-sector indexes, exploiting their fundamental views on specific sectors. Index baskets offer investors timing flexibility and low-cost trading structures, allowing active managers to implement credit duration strategies largely independent from the primary and secondary cash markets. The iTraxx tranches were initially created for mark-to-market purposes and to help book runners manage their P&L accounts, but index tranches are now actively traded and are also being used to trade and/or hedge correlation risk. Because the underlying portfolios and maturity dates are fixed, iTraxx Index Market Makers are also able to quote a range of standard tranches from equity or first-loss tranches, up to the most senior tranches. A particularly exciting by-product of the increased liquidity and transparency in the index market has been the very recent emergence of exchange-traded futures contracts based on the iTraxx Indexes. It is early days yet, but these contracts can provide a new dimension for buy-side organizations to manage credit risk. The outlook When the markets needed a benchmark for managing credit risk, iTraxx provided the tool. It has also stimulated trading activity and provided an efficient means of port-

folio hedging and established itself as a market standard. By adding liquidity and transparency to the markets, the iTraxx family also helped establish credit risk as an asset class in its own right an asset class that is now every bit as complex as other more established markets such as equity. This success could not have been achieved without the goodwill and cooperation of investment banks, but especially not without the input of investment managers. Having identified the need for indexes and hedging instruments and pushed for their development, this community played a pivotal role in iTraxxs development. Investment managers will likely continue to press for products and opportunities to

serve their changing needs. At the same time, credit derivative products will likely become more widely accepted. This will mean that those players still prevented from using the instruments by mandates or regulations will soon enter the market. Those using credit derivatives for the first time will likely use the standardized indexes or instruments based on them, such as the new futures contracts. All these factors will continue to drive the credit derivatives market and in particular, the index market, fuelling volume and liquidity. The International Index Company will remain at the forefront of activity, spearheading the markets development with the principles of independence, transparency and objectivity at its core.

International Index Company Ltd. (IIC) is the market leader for fixed income and creditderivatives data and indexes. Established in 2001, IIC calculates and publishes the independent iBoxx bond prices using multiple price contributors and rigorous quality controls. The iBoxx bond indexes set new standards in the investment community for transparency and accessibility and have been adopted by the market for use as benchmarks, in research and as the basis for financial products. The index families include the iBoxx euro, British pound, U.S. dollar, global inflation-linked, ABS and euro high yield bond indexes. IIC also manages and administers the iTraxx European and Asian Credit Derivatives Indexes, and calculates and distributes the iBoxx FX trade-weighted foreign exchange indexes for ten major currencies. IIC is owned by ABN AMRO, Barclays Capital, BNP Paribas, Deutsche Bank, Deutsche Brse, Dresdner Kleinwort, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley and UBS.

Tobias Sprhnle joined IIC in 2006, where he is head of derivatives. In this role he is responsible for the global iTraxx Credit Derivatives Index families. He holds a diploma in economics and information management and is a chartered financial analyst (CFA). After starting his career in the German private banking industry, Tobias joined Eurex/ Deutsche Brse Group in 2000, where he occupied different roles in market supervision and product design for fixed income derivatives. In his role as a product designer, he was project manager for the iTraxx Credit Futures products, the first exchange-traded credit derivatives in the world.

38

The landscape

The upsidesCredit derivatives rose from obscurity to become mainstream derivatives instruments in record time. Natasha de Tern finds out how they have benefited the wider financial markets

The landscape Case studies

39

T

he creation of credit derivatives had indeed transformed the world of finance, strengthening the banking system and reinventing credit as a

former Federal Reserve Chairman Alan Greenspan told a gathering at the Bond Market Association in New York last year. Among other things, he said, it has made the banking sector more resilient. Greenspans best illustration of his thesis was that between 1998 and 2000, the peak of the Dotcom boom, the equivalent of USD 1 trillion of debt had been taken out by the telecommunications industry, of which a significant part went into default. Yet not a single major U.S. financial institution ran into difficulty because, when the Dotcom bubble burst in 2000, the credit derivatives market had played an effective role in defusing the very major credit problems. The new market had passed its first test. The enhanced resilience of the banking sector is the common thread that runs through many of the comments made by regulators and central bankers over the past five years. Although, it must be noted that they, as circumspect guardians of the financial system, have also warned the world of its darker side but more of that in the next chapter.

Mitigating risks As the credit derivatives market grew unabated after 2000, it continued to face more challenges because low interest rates were stoking an ever-increasing appetite for debt, while rising energy and commodity prices were testing the markets tolerance for risk. The Reserve Bank of Australias deputy governor, Glenn Stevens, noted in 2006: A striking feature over the past several years has also been the way in which a succession of events that might previously have triggered a significant disturbance in financial markets have been absorbed relatively easily. Two of the events to which Stevens may have been referring were the twin credit ratings downgrades to junk of the world's two biggest car manufacturers and corporate debtors, General Motors and Ford, and the biggest hedge fund liquidation in history, that of Connecticut-based, Amaranth Advisors. Market practitioners were equally quick to point out that the parallel existence of the seemingly unflappable financial marketplace and the growth of credit derivatives has not been mere coincidence. We have been through several market corrections in the past few years and in each case, markets have recovered, said Anshu Jain, Deutsche Bank's head of global markets and the chief architect of the German banks reinvention as a global derivatives powerhouse. In retrospect, people think the market has been characterized by calm, continuous and even benign conditions. Derivatives are a big part of explaining that phenomenon, he added. The development of the interest rate swaps market in the 1980s left bankers grappling to find a tool to manage their other major risk

streamlined asset class.

Historically, debt had financed much of

the worlds corporate activity, but credit had been overshadowed by its headlinegrabbing cousin, equity, which was perceived as a more exciting asset-class that was easier to access and, in most cases, offered higher returns. The low-key perception of debt masked its potential importance in global capital markets. Few people outside Wall Street could have predicted the impact that credit would have on financial markets once the smartest brains in finance had developed an effective risk-transfer tool that was the equivalent of turning tin into silver. Perhaps the most significant development in financial markets in decades has been the rapid development of credit derivatives, the

As the credit derivatives market grew unabated after 2000, it continued to face more challenges because low interest rates were stoking an ever-increasing appetite for debt

40

The landscape

banks are increasing the supply of credit as

Historically, banks lending practices had been constrained by their inability to dispose of loan risks that they no longer wanted to holdcredit. Historically, banks lending practices had been constrained by their inability to dispose of loan risks that they no longer wanted to hold. In practice it was possible, but it was a convoluted process. The market for loan trading was illiquid and the borrower had to be notified of the transfer, which risked jeopardizing the entire banking relationship with the customer. Moreover, in the case of an economic downturn, banks were forced to cut the amount of loans they issued, creating a credit crunch effect. This typically led to higher borrowing costs, and ultimately defaults, which affected the wider economy. Loans sat stagnating on banks balance sheets, exposing them to potentially huge losses in the event of a major default or series of defaults. Perversely, in some cases, banks would actually increase the amount of loans to healthier corporate sectors as a way of diversifying their risk. Credit derivatives made the process fluid, while keeping their core business intact. Credit default swaps are transforming the way banks operate in the market, and due to credit portfolio management practices have Minimizing costs As this decade has progressed, the needs of the customer have been met not only by the availability of credit, but also in cheaper funding costs. Credit derivatives cannot take all of the plaudits, of course, because strong economic growth, low interest rates and a consumer boom since 2002 have kept default rates near an all-time low. Nevertheless, the banks growing use of credit derivatives has freed up more capital to make more loans and generate more fees, without them having to set more capital aside for regulatory purposes. Indeed, as Trichet said in the same speech: Some evidence from the United States, based on individual loan data, supports the idea that indeed profound implications for the banking business model, Jean-Claude Trichet, president of the European Central Bank, told delegates at the International Swaps and Derivatives conference in April 2007. Banks increasingly find credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books, while simultaneously allowing them to meet the needs of their corporate customers.

they obtain additional credit protection through credit derivatives. The increased agility of the banking system has also led to a reassessment of what is suitable credit risk, and this has reinforced the already low default rates, which has brought wider implications for the economy as a whole. The changing shape of business banking and risk management was further streamlined by the rapid growth of so-called synthetic collateralized debt obligations (CDO). These ingenious examples of financial engineering enable banks to bundle together groups of credit default swaps (CDS), dividing them into parcels of varying risk, before selling them on to investors. Synthetic CDO volumes surged from 2004 after banks created credit derivatives indexes, which became the building blocks for CDOs and other products, enabling banks to further slice-and-dice risk according to their view of the financial health of companies. Investors benefited from gaining exposure to a group of companies of their choice, without having to source the individual underlying bonds. The first CDOs had been composed of corporate bonds, which took many months to bring together. The market accelerated with the onset of credit derivatives, and CDS indexes in particular, because banks could package them together much more swiftly in some cases, in one day. The proliferation of synthetic CDOs led directly to a compression of credit risk premiums. The CDO market now stands at USD 1.5 trillion, having grown by more than USD 500 billion last year, according to Morgan Stanley. Although just a fraction of the overall size of the credit derivatives

The landscape

41

market of USD 34.5 trillion, the markets impact on credit spreads has been significant. As banks built the CDOs, typically they would hedge their positions by selling CDS in the market. At a time when investors and banks were less concerned about company defaults, there was less demand to buy CDS and credit risk premiums fell to near record lows as a result. According to Standard & Poors Leveraged Commentary & Data unit, for instance, U.S. junk-rated companies now pay an average spread of 2.38 percentage points more than LIBOR, a record low, compared with more than 4 percentage points in 2003. To illustrate the benefits of this large-scale dispersion of credit risk, consider the example of Eastman Kodak, the worlds largest photography company. By mid-2005, the once blue chip company had reported losses totalling USD 1.6 billion over six consecutive quarters and its credit rating had been cut three times by Moodys. In a world without credit derivatives, banks might have balked at the prospect of lending further to the company. Yet Kodak was still able to borrow USD 2.7 billion at 0.75 basis points less than it had three years earlier. That may have been due to its CDS being contained in more than 150 CDOs, according to data from bond research firm, CreditSights. Eastman Kodak duly secured the funding it needed to fight another day. In this case, the CDS market had helped avoid the possibility of a default and the prospect of thousands of job losses. Attracting new investors As with all asset classes, the premise of CDS rests on its effectiveness as a risk

management tool, or in common trader parlance, the ability to go short. For generations, corporate debt investors had been hamstrung by their inability to hedge bond portfolios; when credit conditions worsened, risk premiums rose and companies started defaulting on their bonds. For many fund managers it represented a critical barrier to entry. And for those involved in the debt markets, the choices were few: they either bought more bonds to diversify or became forced sellers. In practice this was time consuming, inefficient and expensive. Restocking the portfolio made things even more expensive. The introduction of the iTraxx Indexes in 2004 made life a whole lot easier. Soon, much credit derivatives trading activity was based on the indexes, making the difference between the buy and sell rates (or the bid/ offer spread) small and the cost of hedging a bond portfolio significantly cheaper, in turn, making the process much faster. It is also arguable that the increased use of credit derivatives by fund managers after 2004 contributed to a reduction in corporate risk premiums. In the past, investors had demanded what was known as a liquidity premium. They wanted to be rewarded sufficiently to compensate for transactional risks, and, as a result, borrowing rates were artificially higher than they should have been. Borrowers were attracted to the longer-term funding that the bond market provided, not to the lending margins they were offered. The adoption of credit derivatives as a more effective way of hedging their bond portfolios gave investors more flexibility, or, as one private equity manager recently put it, meant that there had never been a cheaper time to go to the bond market.

42

The landscape

The darker side of credit derivativesThe rapid expansion of the credit derivatives market came at a price. John Ferry exposes the flaws and teething problems

The landscape Case studies

43

Tpositives, emerged.

he emergence of the credit derivatives market clearly produced some well-documented benefits for both the individual buyers and sellers of

processing credit derivatives contracts in their back offices, as well as how legal, counterparty, liquidity, concentration and other risks might be casting a shadow over the growing market. Nearly all the risks were highlighted in an October 2004 report produced by the Financial Stability Forum (FSF). The FSF had requested its Joint Forums Working Group on Risk Assessment and Capital undertake a review of credit risk transfer (CRT) activity. The report was based on a number of interviews and discussions with market participants and noted the importance of considering the financial stability issues that could be associated with CRT activity. It highlighted several key risk management risks associated with CRT: operational risk, counterparty credit risk, legal risk and liquidity risk. Processing issues and operational risk Ironically, in view of the sophistication of the markets tools and techniques, the infra-

structure that supported credit derivatives operations was based on old-fashioned systems and outdated technology. All OTC derivatives are cumbersome to confirm, but operational advances over the years had eased the processes for many product types. Credit derivatives, by comparison, did not enjoy the same levels of operational streamlining. Credit derivatives have some peculiar features that mean the back-office paperwork is hugely important. Unlike more established and standardized interest rate and equity derivatives, credit derivatives trades have to be supported by lengthy documentation outlining the terms of the deal. The complexity of the instruments and the rapid growth in volumes only exacerbated the associated paperwork burden and the operational shortfall. Back-office controls are particularly important for the credit derivatives market because when two parties agree a sale they are effectively transferring the risk of default on a bond, or group of bonds. But the contract does not become valid until all the

credit risk, and for the

financial system as a whole. But as the market for credit default swaps (CDS) and other forms of credit risk transfer continued to expand exponentially and become more established and as the structured credit products that referenced these instruments continued to grow so negatives, as well as The regulators were not unaware of the issues. Financial regulators often talk publicly about the development of the overthe-counter (OTC) derivatives market and their associated concerns. But during the early years of this century they increasingly turned their attention to credit derivatives. Their worries centered on how banks were

Credit derivatives trades have to be supported by lengthy documentation outlining the terms of the deal

parties sign the documents, or confirm it electronically. The hypercharged expansion of the market meant that the dealers' ability to process such trades was severely tested and it is probable that all participants fell behind in confirming the often-complex terms involved in transactions. The Joint Forum Report said: CRT activity also gives rise to operational risks. Most significantly, the OTC derivatives market generally has struggled to develop transactions processing and settlement mechanisms that reduce operational and settlement risks. The relevant issues include backlogs of unsigned master agree-

44

The landscape

whether a default had actually occurred.

Controversy arose in 2000 with the restructuring of loans to Conseco, when banks agreed to extend the maturity of the companys senior secured loans in return for higher coupon and collateral paymentsments and unsigned confirmations, as well as the prevalence of manual systems and the risk that they break down with increased volume. In the CDS market, especially, market participants recognize that the problem of unsigned confirmations had reached excessive proportions, with some transactions going unconfirmed for months. Legal risk In terms of legal risks, the Joint Forum summarized the issue as follows: Market participants agreed on the paramount importance of legal certainty in these types of transactions, but emphasized that this requires significant work to ensure it is achieved. Legal or contract risk had, indeed, been a perennial issue in the credit derivatives market since its inception. As bilateral OTC deals, CDS require close legal scrutiny by those signing the contracts, which is why many credit derivatives desks often have lawyers sitting nearby. Jean-Claude Trichet, president of the European Central Bank, returned to the theme of legal risk in an address to the International Swaps and Derivatives Associations (ISDA) annual general meeting in April 2007: It is important that market participants clearly understand the precise rights and obligations which they assume when entering into credit derivatives transactions, as standardized contracts do not always work out in the way that contracting parties anticipate, he said. Also, in some cases, case law has demonstrated that the courts can take divergent views regarding the meaning of ISDAs definitions of credit derivatives. In the most basic of instances there has been confusion between the buyer and seller of CDS regarding the specific legal entity on which the CDS was written. In other cases, market participants entered into contracts on the wrong legal entity. But over the years other issues emerged, such as CDS dealers arguing over the wording of contracts, or

Further difficulties arose out of restructuring events. The 1999 ISDA definitions included debt restructuring such as lowering a coupon or extending maturity as a designated credit event that would trigger repayment on a CDS. Controversy arose in 2000 with the restructuring of loans to Conseco, when banks agreed to extend the maturity of the companys senior secured loans in return for higher coupon and collateral payments. This triggered protection on about USD 2 billion of CDS. David Mengle, ISDAs head of research, noted in his paper, Credit Derivatives: An Overview, that: Protection buyers then took advantage of an embedded cheapest to deliver option in CDS by delivering longerdated senior unsecured bonds, which were deeply discounted worth about 40 cents on the dollar relative to the restructured loans, which were worth over 90 cents on the dollar. Protection sellers ended up absorbing losses that were greater than those incurred by protection buyers, which led many sellers to question the workability of including restructuring. The result was a modification to the definition of restructuring that placed some limits on deliverable bond maturity and, therefore, on the cheapesttodeliver option. ISDA had published standardized credit derivatives definitions in 1999, as a basic framework for documentation. These underwent various modifications and were then updated in 2003 in response to the many problems that had emerged, highlighting legal risks to market participants. But even so, legal doubts remained. In 2006, for example, Aon Financial Products and Socit Gnrale engaged in a court battle over a CDS on the Republic of

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the Philippines. Aon had sold protection to Bear Stearns on a Philippine corporate backed by a government agency. It then bought sovereign protection on the Philippines from the French bank. Market observers assumed this was done to hedge the contract Aon had sold. The Philippine agency subsequently withdrew backing for the Philippine corporate triggering default on the contract Aon had sold. This event did not, however, trigger a payout on the Aon-Socit Gnrale contract, and so a dispute emerged. A U.S. court ultimately upheld the content of both buy-and-sell contracts, with the result that Aon was obliged to honor its payout to Bear Stearns but did not receive compensation from Socit Gnrale. Counterparty credit risk As bilateral OTC derivatives trades, CDS necessarily entail credit risk exposures, namely the credit risk of the counterparty to the trade. For instance, a bank that buys protection against a reference entity through a CDS will rid itself of that particular credit risk, but at the same time it will take on the risk that the counterparty selling the protection might not be able to pay out. Likewise, a protection seller takes on counterparty risk because the seller will lose expected premium income if the buyer defaults. Although banks and other institutions generally have strict procedures for checking and evaluating counterparties, counterparty risk will always remain. Lars Nyberg, deputy governor of the Swedish Central Bank, drew attention to this risk in a speech earlier this year, saying: Counterparty risks exist in most financial agreements, but as the credit derivatives market is so young and growth is

so rapid, there is particular reason to be aware of them. The Joint Forum noted how market participants manage this counterparty credit risk in various ways. One of the most common methods is by way of a collateral support agreement (CSA) that accompanies the ISDA trade documentation and that requires lesser counterparties to post additional collateral against their trades. CSAs are, however, operationally burdensome. To work effectively, they require constant oversight and administration with periodic marking-to-market and margin and collateral adjustments as pre-agreed thresholds are breached. An additional complication that can arise both in regard to the evaluation of counterparty credit risk and the value of credit

protection provided by CRT instruments and CSA agreements concerns the potential correlation that can exist between an underlying reference entity and the protection seller. For example, if the CDS protection sellers credit risk is highly correlated with the credit risk referenced in the CDS itself, the extent of credit risk reduction for the protection buyer is much less than if the protection seller were largely uncorrelated to the reference entity. Some OTC market participants set up Special Purpose Vehicles (SPV) and ran their derivatives trades through them. The SPVs stood in the middle of the deals becoming the trade counterparty to both sides. While this removed the counterparty risk element, it added extra layers of complexity, expense and organizational difficulty.

Although banks and other institutions generally have strict procedures for checking and evaluating counterparties, counterparty risk will always remain

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The landscape

Liquidity risk Related to the issue of counterparty risk is liquidity risk. The CDS market is heavily concentrated among a limited number of dealing banks, while the real liquidity is centered on a relatively small amount of reference entities: less well-known names are traded only infrequently, and many structured deals have no real liquidity at all. Given the lack of transparency in the market, it is impossible to predict how the market will cope under extreme circumstances. This issue was raised by the Joint Forum, has repeatedly been revisited by regulators, and was aired again in May this year when Donald Kohn, vice chairman of the board of governors of the U.S. Federal Reserve, spoke at a conference in Atlanta. There he warned that the credit risk transfer markets are dependent on a small set of key intermediaries, and that, in the extreme, price variations and other adverse developments could call into question the viability of these intermediaries, threatening a larger cumulative real effect. Concentration risk Related to the above two risks are concentration risks. These were highlighted in several Fitch reports most particularly the rating agencys 2002 study: Liquidity in the Credit Default Swap Market: Too Little Too Late? and a 2003 report, Global Credit Derivatives: Risk Management or Risk? The 2002 study found on the one hand that liquidity (even in commonly traded names) tended to dry up in times of stress, after rating agency downgrades and in high volatility periods. The 2003 study, meanwhile, highlighted the dominance of just a few dealers as measured by the gross amount of protection sold, the top 30 global banks and broker dealers held approximately 98 percent of positions. Worse, counterparty Opacity risk The general opacity of the market is another issue that cannot be ignored. In the OTC markets, buyers and sellers of risk are not obliged to disclose details of particular CDS deals. As recently as 2006, Frank Partnoy and David Skeel of the University of Pennsylvania Law School noted in their paper, The Promise and Perils of Credit Derivatives: The market for Credit Default Swaps is quite opaque. Because swaps are structured as OTC derivatives, they are largely unregulated. Increasing liquidity in the CDS market helped improve pricing transparency for the most liquid credit derivatives, but this has not stopped some market observers from calling for formal moves to be made on OTC deal and pricing information. Although there is some price transparency in certain segments of the credit default swaps market, we believe there should be a centralized pricing Advances The Joint Forum report then remains as important today as it was when it was first published. Although considerable advances have since been made many of them in direct response to the reports findings the significance of the issues raised has not diminished. risk was concentrated among just the topten global banks and broker dealers. service for credit derivatives generally, stated Partnoy and Skeel in their paper. To a limited extent, centralized pricing services do currently exist (though these are non-obligatory), but highly esoteric credit derivatives and CDS written on less liquid names are another matter. For complex, or bespoke products nth-to-default derivatives on a basket of credit exposures, for example pricing can be highly subjective. Such derivatives are generally marked to model rather than marked to market, which means the pricing is only as good as the veracity of the underlying quantitative model used, as well as the inputs to that model.

The market for credit default swaps is quite opaque. Because swaps are structured as OTC derivatives, they are largely unregulated

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Regulatory interventionThough regulators largely welcomed the advent of credit derivatives, they soon realized that there were abundant flaws in the systems that supported the products. John Ferry explores the lead-up to regulatory intervention

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n February 2005, the U.K. Financial Services Authority (FSA) was prompte