Dealers sceptical of new CDS futures despite market shift

Fri Apr 12, 2013 10:19am BST

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* ICE to launch four CDS futures in May

* Greater sandardisation opens door to listed products

* Market players concerned over new contract design

By Christopher Whittall

LONDON, April 12 (IFR) - Standardisation and electronic trading for OTC derivatives are helping dealers warm to the idea of CDS futures, but as four new contracts prepare to launch in May, many remain sceptical.

Dealers have long been reluctant to support initiatives that could hurt their swaps profits, while the question of CDS triggers has been hard to resolve.

Though previous attempts to get CDS futures off the ground have sputtered, Intercontinental Exchange (ICE) believes there will be strong interest in its four new contracts based on the most liquid US and European indices: CDX NA IG, CDX NA HY, iTraxx Europe (Main) and iTraxx Crossover.

Dealers still express concern over the design of the contracts, which aim to circumvent potential pitfalls around credit events, but ICE - which clears USD35trn in gross notional CDS worldwide - says their new products will show the market's time has come.

"Dealer support for previous attempts was ambivalent or even hostile, but now there is a trend towards more futures style markets," said Peter Barsoom, COO at ICE Clear Credit.

"There are significant players who want to express credit views but find it hard to do so via swaps," he told IFR. "We feel that introducing futures will create synergies and complement the swaps market as well."

BETTER, BUT GOOD ENOUGH?

Previous attempts from Eurex, CME and Liffe to launch CDS futures never really got off the ground in the pre-2008 financial crisis era.

Without question, the CDS market has come a long way since those first efforts to create a listed product in the credit space.

Liquidity has dramatically shifted towards index products, which have increasingly resembled a standardised, listed market.

In the first week of April, USD77bn of gross notional traded on the iTraxx Europe Main index - one of the indices ICE is using for the new contracts - compared to USD26bn in the same week back in 2009.

Competition is showing signs of ramping up. S&P Dow Jones Indices launched three new CDS indices on the S&P500 on Wednesday and has licensed trueEX, an exchange, to create accompanying futures contracts.

As with futures, the most liquid CDS indices are now traded electronically. This has compressed bid-offer spreads, eroding dealer margins and so dampening their incentive to veto futures products in the process.

Moreover, dealers have to hold more capital against swaps positions under new regulations, making them less attractive to trade for capitally-constrained banks, Barsoom said.

But many in the market remain hesitant - and the new contracts launching next month already have garnered a number of sceptics and detractors.

"I've always been a big proponent of simplifying the product, and think if they are able to structure a simple futures product, it will attract interest," said Tim Gately, European head of credit trading at Citigroup.

"That being said, I think the jury is still out on whether this has been accomplished."

KNOWN UNKNOWNS

Among other gripes, several traders have expressed concern about the ICE's "when issued" format - meaning investors will trade futures on an index without knowing the constituents.

Markit reviews its index constituents every six months and substitutes in names using a rules-based approach.

Yet while there are rarely radical changes - most index rolls add or subtract no more than 10bp from the previous index level - some investors still don't like the idea.

"I think it is difficult for anyone to price a security before knowing what the names are," said one credit hedge fund manager."

"I don't see anyone - buy-side or sell-side - having any interest in [these futures]," he said.

The ICE believes that "when issued" helps to get round the tricky issue of CDS triggers and credit events.

ICE's Barsoom conceded there were legitimate questions about the functionality, but believes the market will get comfortable with the futures over time.

After all, he said, equity traders trade long-dated futures contracts on the S&P500 index without knowing the exact make-up of the index.

INEVITABLE SHIFT?

Despite the complexity of launching futures in the credit space, many believe the stars are aligned for a shift to more standardised products.

Overall CDS volumes may have plummeted following the abrupt halt of the structured credit boom in 2008, but index trading has flourished. The four Markit indices ICE has singled out are by far the most liquid in the market.

Meanwhile, enforced clearing and electronic execution of OTC derivatives under the US Dodd-Frank Act has led to a debate over the extent to which futures may grab market share away from OTC swaps.

Certainly, there is a clear economic incentive for investors to trade listed products where possible: traders have to post five times more margin against swaps than they do against futures.

For investors who want exposure to credit spreads rather than default protection, futures could well prove a more efficient instrument.

"Typically 60% to 75% of initial margin is associated with jump-to-default risk," Barsoom said.

"If you're not interested in that risk, you're overpaying on the swap. That's why we created this," he said. "It has a different economic and risk profile from a swap."

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