By John Hintze
There is an air of inevitability that at least some of the business in credit default swaps will migrate to exchanges as new regulations make the OTC variety more cumbersome and costly to deal with.
As volumes in interest-rate swap futures steadily climb, derivative exchanges are counting on the same regulatory factors to increase the attractiveness of exchange-traded credit derivatives, a product they say corporates could put to work in a variety of ways.
In fact, there is almost an air of inevitability that at least some of the business in credit default swaps (CDS) will migrate to exchanges as new regulations make the over-the-counter (OTC) variety more cumbersome and costly to deal with, and the benefits of transparent and liquid exchange-traded markets to hedge credit risk become more apparent.
“We’re always evaluating single names as well as indices we might do in the credit space, because we do believe it’s potentially a rich area for the CBOE,” said Dennis O’Callahan, director, research and product development, at the Chicago Board Options Exchange.
The CBOE launched credit-default options more than two years ago, and that effort was a revival of an earlier attempt in 2007. The Chicago Mercantile Exchange (CME) launched a credit futures version in 2007 as well, but neither initiative caught on as the financial crisis—in part instigated by CDS—began to unfold.
Indeed, despite the CBOE’s persistence, the exchange’s contracts have yet to attract significant volume. The CME declined to comment on whether it would seek to relaunch its credit futures products. However, the Intercontinental Exchange (ICE) and a new futures exchange, trueEx, plan to launch futures based on indices of credits this year, suggesting demand for credit derivatives is brewing.
Sunil Hirani, co-founder and CEO of trueEx and co-founder of the Creditex Group execution and brokerage platform for CDS that was sold to The ICE, noted that the CDS market has become “dysfunctional” and has a dearth of new clients. trueEx announced April 10 that it had licensed three credit spread indices that were recently launched by Standard & Poor’s, and Mr. Hirani said trueEx plans to offer credit futures based on those indices, probably in the third quarter.
“Credit risk is one of the most ubiquitous risks in the system, but there’s no efficient way to manage it,” Mr. Hirani said, adding that launching credit futures is a way “to provide a product that will have broad appeal.”
None of the exchanges view corporates as first adopters of exchange-traded derivatives. However, if the contracts do gain liquidity—and new rules stemming from the Dodd-Frank Act and Basel III capital guidelines do appear to be increasing interest in exchange-traded swap futures (see related story on iTreasurer.com, “Capital Markets: CME’s Deliverable Swap Futures Pass Major Tests“)—then exchange-traded credit derivatives could be a key tool in a treasurer’s tool bag.
The ICE was prescient in launching the first CDS clearinghouse in March 2009, soon after financial markets around the world collapsed and CDS were pegged as one of the main culprits. Regulators have since developed rules that push more transparent central clearing facilities and eventually exchanges as solutions to mitigate derivatives’ risk, and in the CDS market The ICE has captured the vast majority of the clearing business.
Peter Barsoom, chief operating officer at ICE Clear Credit, said the company plans to offer four credit futures based on Markit credit indices, with the first covering credit instruments from North American companies, to be launched in May.
“What we’ve encountered as we talk to users of existing CDS and those who are not currently participating in the credit swap market, is that they generally want a simple, efficient instrument to take a view on overall credit spreads,” Mr. Barsoom said.
Corporates have never had such a tool available to them, so it’s difficult to predict how credit futures will be received when they arrive. Nevertheless, a corporate that invests part of its cash in a basket of commercial paper (CP) issued by US companies could hedge that credit risk by trading a future that represents where overall US macro credit spreads are going, such as the first contract ICE plans to launch.
“That’s one way to hedge out a portfolio of CP, and today there’s no simple way to do that,” Mr. Barsoom said. He added that a manufacturer’s financing arm could potentially use an index credit future to hedge the risk of spreads widening on its portfolio of loans to customers. Or, a treasurer of a company with credit exposure to other European corporates potentially impacting its core revenue could use ICE’s anticipated futures based on indices of investment-grade or high-yield debt of European companies.
Each index measures credit risk five years forward, and each contract calls for cash-settlement at expiration, with the final settlement value based on the price of the referenced swap series cleared by ICE’s CDS clearinghouses.
trueEx plans to launch interest-rate swap contracts in the second quarter, followed by the credit futures. One credit contract will be based on an index of the outstanding investment-grade debt issued by the 30 largest financial institutions in the Fortune 500 index, while a second will be based on the outstanding investment-grade debt of the 120 largest corporates, and the third contact will comprise both indices.
Recent news reports suggest federal regulators have been increasingly successful persuading market participants that the regulatory infrastructure under the Dodd-Frank Act does indeed permit the largest financial institutions to fail. Those same financial institutions also tend to be among the biggest swap counterparties.
Mr. Hirani said that his firm’s contract based on the financial firm credit index would enable users to hedge the potential deterioration of those credits along with the consequent widening of spreads in their swap portfolios. “As the creditworthiness of swaps counterparties deteriorates, this would be a way to express that view,” Mr. Hirani said.
Some CDS are based on indices of credit as well, and many more are based on the credits of individual institutions. OTC swaps, however, tend to have much wider spreads than exchange-traded contracts, and so are costlier, and counterparties must maintain credit support annexes.
In addition, they present significant bilateral risk, as the financial crisis clearly illustrated. Although corporate end users have been exempted from clearing and many reporting requirements, which are coming into effect this year (see related story), their financial counterparties are expected to pass on to them whatever additional costs they face.
Those are all factors anticipated to create demand for more transparent and less cumbersome exchange-traded derivatives, prompting at least some swap business to migrate to the exchanges. It may take a while, however, before corporates’ interest in the contracts becomes clearer.
Tom Deas, treasurer at FMC Corporation and chairman of the National Association of Corporate Treasurers, noted that buying credit protection using a futures contract in today’s low-rate environment would likely result in a negative return on the initial investment. In any case, he said, corporates have tended to hedge investment risk through diversification, often investing in money market funds actively seeking that diversification. “Where this might work is when rates rise,” Mr. Deas said, “and a money market manager could invest in commercial paper and other assets in the same proportion as the index, and then bundle those investments with a [credit] future contract for protection.”
The CBOE has taken a different strategy and developed Credit Event Binary Option (CEBO) contracts tied to the credit of individual companies. It launched the most recent effort two years ago with mostly corporate names. Now half of its contracts are based on credits from major financial institutions, including Citibank, J.P. Morgan, and Bank of America.
“One of the things treasurers learned from the 2008 financial crisis was that they operate under committed credit facilities of a syndicate of lenders, and they could have a defaulting lender,” Mr. Deas said, adding, “several companies had Lehman Brothers for 10 percent or 15 percent of their credit agreements, and those commitments got hung up in the crisis.”
Today, Mr. Deas said, companies seek to mitigate that risk by carefully choosing their bank groups and monitoring their lenders’ creditworthiness, and one tool has been tracking those banks’ CDS spreads.
“To the extent these credit derivative products provide another data point for doing that, then they could be useful,” Mr. Deas said, adding that their smaller increments—CBOE’s options trade in $1000 increments compared to increments of $5 million or more for CDS—could improve pricing efficiency.
The Chicago-based exchange’s CEBO for Bank of America that expires on Dec. 27, 2013, for example, showed a bid of two cents and an offer of 11 cents on April 18. “The midpoint is 6.5 cents,” O’Callahan said, adding, “That means there’s an approximately 6.5 percent probability of default before or on Dec. 27, 2013.”
Commissions for trade exchange-traded products are minimal. In terms of premiums, the Bank of America contract’s 11 cent offer means protection would cost 11 percent of the value of the contract upfront, or $110 for every $1000 increment. Mr. O’Callahan said the true market is probably somewhere inside the bid/ask spread.
Payout on the option would be determined by a single credit event, bankruptcy. If the credit deteriorates but no bankruptcy occurs before expiration, the contract holder can still benefit. For example, if Bank of America’s credit standing deteriorates and the bid/offer move to 32 cents and 41 cents, respectively, investors in the option today would capture the price differences between the time the trade was entered and the current market.
“Buying one of these for an expiration date, you could tailor your exposure to these financial entities,” Mr. O’Callahan said.