HUNTINGTON BEACH, Calif. — For fixed-income investors, few words cause more fear in the over-the-counter credit derivatives market and its whopping $26 trillion notional value than default and bankruptcy.
And investors were reminded of the notion of risk by the Feb. 27 stock market sell-off, which was tied to worries over U.S. economic growth, subprime lending and emerging markets.
The return of risk awareness has widened yields and resulted in some bond issues canceled or higher premiums for recent bond offerings.
The Chicago Mercantile Exchange and the Chicago Board Options Exchange each is coming up with new contracts that will help asset managers buy insurance against such events affecting their fixed-income holdings.
James Grady, senior portfolio manager for structure financed securities at Deutsche Asset Management, New York, believes a reassessment of risk is a healthy development for bond investors. Deutsche Asset Management has a fixed-income portfolio of more than $100 billion across investment grades.
“Corporate credit spreads had been very tight, close to all-time tight, and have given a little back,” Mr. Grady said, noting there were many long positions in the investment-grade sector. “We have seen a reversal of that. Ultimately, it is healthy for the market. We are at a point where the pricing of risk is richer than the fundamentals warranted and this has reminded people that these assets are risky.”
The new contracts are yes-or-no binary offerings, betting on the view that a credit event will occur or not. They are based on securities at the CBOE, and on futures at the CME. They allow investors to buy insurance against an event negatively affecting a bond while sellers of the contract collect a fee for the insurance they extend.
“Bankruptcy and failure to pay are two primary risks in the credit derivatives market. We will be launching a credit event index contract in the second quarter,” CME Managing Director Robin Ross saidin an interview at the annual risk-management conference held by the Chicago exchanges in Huntington Beach, Calif., on March 4-7.
CFTC filing
The CME has just filed with the Commodity Futures Trading Commission its plan to launch credit index event contracts “to extend to the credit derivatives industry the benefits of exchange-traded products, which had only been available on an OTC basis,” Ms. Ross said.
Pending regulatory approval, the CME North American Investment Grade High-Volatility contract is tentatively set to launch April 23. It will track 32 corporate issuers, such as Time Warner Inc. and Viacom Inc. The CME will reconstitute this and other upcoming indexes every March and September.
The new offering is part of the CME’s long-term strategy to expand its presence in the OTC markets and migrate some OTC trading to an exchange-listed environment, given the sheer size of the OTC markets and their mature stage.
The CME last summer bought London-based Swapstream, an electronic trading platform for euro- and Swiss franc-denominated interest rate swaps. It is readying the launch of FXMarketSpace, a joint venture with London-based Reuters Group PLC to trade foreign exchange in a listed environment with the benefit of central counterparty clearing.
“We are going to add U.S. dollars to Swapstream early in the second quarter. It will be a soft launch in Europe and we will introduce that platform in the U.S. before the end of the year. We also have plans to add sterling,” Ms. Ross said, adding the CME intends to broaden participation in Swapstream, including hedge funds, beyond its dealers’ constituency.
“Basically, we are taking things that we are very good at — the transaction process and clearing — and taking those efficiencies to the OTC market,” she added.
The CBOE also wants to move into a market mature enough to benefit from exchange-traded products.
On Feb. 7, the CBOE filed with the Securities and Exchange Commission “for the listing and trading of cash-settled, binary options based on credit events in one or more debt securities of an issuer, according to the filing. CBOE default options are binary call options that cover payment default or a restructuring of the debt.
Joe Levin, CBOE vice president for research and product development, said the exchange’s move into the credit event area was not in response to the CME’s initiative but an “evolutionary process.”
“Exchanges will focus on credit risk. Risk is priced and traded over the counter, which is an opaque market. Hedge funds — and anybody who is in credit derivatives — are looking for a more transparent market,” Mr. Levin said. “Given that we trade equity options, and given the relation between credit risk and equity risk, offering credit default options is a natural extension of our offering.”
Liquidity is key
For Jose Marquez, senior vice president, portfolio management, at Deerfield Capital Management LLC in Rosemont, Ill., liquidity will be the key factor in whether the contracts take off as exchanges attempt to capture some of the huge liquidity available in the OTC market.
In mid-2006, the latest data available, Deerfield managed $12.4 billion under 23 structured products, including 22 collateralized debt obligations and a structured loan fund, as well as five hedge funds and a real estate investment trust.
“The CME will be doing the clearing, which is going to add transparency to the trading of such instruments. This will allow people who trade those instruments to reduce counterparty risk,” Mr. Marquez said.
“One thing that would be important for the success of these products would be liquidity and finding the right participants,” Mr. Marquez added. “Dealers make money through the flow, so it might not be in their own interest to trade on an exchange if the OTC market is where they make their money.”
Regarding the CBOE products, he added, “These products fill a gap as they provide something that is not there yet. People who want to hedge go to exchange-traded contracts as a way to reduce counterparty exposure.”
The CBOE had opposed the CME’s filing to list credit event futures, claiming they should fall under SEC jurisdiction because the contracts are related to corporate bonds, which are securities.
“Swaps, which have been listed for trading on at least two futures exchanges, are clearly commodities as defined by the Commodity Exchange Act, and therefore the commission’s exclusive jurisdiction is clear, whether the product is a future or an option, unless the underlying instrument is a security,” the CME wrote in an answer to the CBOE’s comments.
The CFTC has ruled in favor of the CME and already approved three credit event contracts, based on three corporate issuers, and is reviewing the filing related to the index contract.
