Credit Flux Credit Index Trading 2004

7/22/2019 Credit Flux Credit Index Trading 2004

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credit index

trading

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credit index trading

THECreditfluxINSIDE GUIDE TO

Creditflux

LONDON 2004


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The Creditflux inside guide to credit index trading

Written by Lisa Cooper, Euan Hagger & Michael Peterson

Edited by Michael Peterson

Design & production byMiles Smith-Morris & Roger Thomas

Published by Creditflux Limited63 Clerkenwell Road, London EC1M 5NP, UKwww.creditflux.com

Creditflux Ltd, September 2004


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Contents

ONE introduction:a different kind of index 5

TWO the investor viewpoint:benefiting from efficiency 11

THREE index tranches:from esoteric to flow 17

FOUR index option trading:waiting for volatility 23

FIVE trade execution:the pursuit of liquidity 27

SIX infrastructure challenges:coping with the volumes 33

SEVEN the futures of credit indices:deeper, broader, cheaper 41

Glossary 47
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A market in flux needs a fast and reliable source of news and analysis. Subscribers rely on Creditfluxtoexplain what is really happening in the ever changing global market for structured credit and credit derivatives.

And with the most comprehensive database of portfolio credit swaps, Creditfluxhas quickly established itselas the pre-eminent reference source for this fast-growing market. Through monthly print issues, weekly onlineupdates of breaking news and market data, and one-off in-depth reports, Creditfluxincludes: News of deals, innovations, changes to market standards and regulatory developments In-depth profiles of key market players Succinct analysis of points of discussion in the market Latest people moves and internal reorganisations Pipeline of forthcoming deals Reports on credit trading activity Database of completed cashflow CDOs and portfolio credit swaps (synthetic CDOs), credit default swapprices, implied correlations and volatility, defaults and rating actions

Creditfluxis available exclusively to subscribers, who receive 12 print issues a year as well as unlimited access twww.creditflux.com. Subscribe today: go to www.creditflux.com and choose subscribe.

GM seeks alphathrough credi

April 20

Agencies act onCDOs-squared

December 2003

Wachovia sets up

London trading deskFebruary 2004

Morgan Stanley planscredit index floater

February 2004

Recovery swaps set to explodeMay 2004

Creditflux

www.creditflux.com

news and analysis of the global credit derivatives market

Cf

Agencies scupper HVB spin-off plansJanuary 2004

Where do you learn about developments

at the cutting edge of credit?

MBIA drops plans for super-senior hedgeJanuary 2004

JP Morgan trades equity hybrid CDOsFebruary 200

Primus looks to single-tranche riskFebruary 2004

The inside guide to portfolio credit swapsMarch 2004

Volatility trading takes flightApril 2004

Nikko loses CLNs case against UBSMarch 2004


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introductio

Chapter 1introduction:

a different kind of index

When at the beginning of 2002 Morgan Stanley developed Tracers,the pioneer of a new breed of tradable credit indices, the model

the bankers had in mind was an exchange-traded fund. Earlierattempts to create liquid instruments that tracked the investment-grade creditmarket, such as bond funds, were hampered by a lack of liquidity and by thetendency of these products to develop their own technical forces, pushing themout of kilter with the index.

With Tracers, as with ETFs, the price of the instrument would be kept inline with the index it is supposed to follow by arbitrage. Investors could, at anytime, redeem their holdings and receive all the underlying bonds. Like ETFsin the equity markets, it was hoped that Tracers would become a highly liquidtrading instrument, and channel large waves of investment into the creditmarket.

Two years on, that dream has largely become reality. But not in quite theway Morgan Stanley planned.

For one thing, credit derivatives quickly emerged as a more efficient toolfor constructing the product than the cash structure of the original Tracersand its imitators. Synthetic Tracers, the credit derivative version of Tracers,quickly eclipsed the original product and, along with JP Morgans high-yieldproduct Hydi and European investment-grade index Jeci, set the template forlater launches.

e other big development has been the realisation that tradable indexproducts need to be owned and sponsored by groups of dealers, not by asingle bank. Most of the original batch of proprietary credit derivative indices

have subsequently been folded into the multi-dealer indices known as CDXin North America and iTraxx everywhere else (see Credit derivative indextimeline, page 6).

By suppressing the primeval instinct of all investment banks to developand trade proprietary structures, and by collaborating with their foes to createmarket-wide standards, credit derivative dealers have created a product that hassurpassed all but their boldest ambitions. Todays credit derivative indices tradein volumes that were recently unimaginable for a credit derivative instrument


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6credit index trading

and with sufficient liquidity to attract hosts of new users and a raft of spin-offproducts such as tranches and options (see chapters 3 and 4). Indeed, the sheer

volume of trades has emerged as one of the biggest obstacles to the continueddevelopment of this market (see chapter 6).

A lot has changed since we developed Tracers, says Jared Epstein, headof credit derivatives trading at Morgan Stanley in New York. We used topride ourselves on making a five basis point bidoffer on $10 million. Now

the indices are quoted with a bidoffer of less than half a basis point on $100million.

For many institutions that want to keep track of the price of corporate debt,CDX and iTraxx are the credit market. True, they are not as comprehensive asthe established bond indices such as the Lehman Aggregate, but they allowpeople to observe how the market has moved on a daily and even hourly basis.

e dealing costs for todays credit derivative indices are on a completelydifferent scale to anything ever seen before in the credit market. An investment

Credit derivative index timelineNovember 2001 JP Morgan launches high-yield credit derivative index HydiJanuary 2002 Morgan Stanley launches Tracers, backed by North American bonds

March 2002 JP Morgan launches Jeci, a European credit derivative index traded in funded

format

April 2002 Morgan Stanley launches Synthetic Tracers, a credit derivative version of Tracers

February 2003 Deutsche Bank and ABN Amro launch iBoxx 100, a European credit derivative

index traded in funded format

April 2003 JP Morgan launches Emdi, an emerging market credit derivative index

April 2003 Morgan Stanley and JP Morgan merge Hydi, Jeci, Tracers and their respective

Japanese indices to form Trac-x

July 2003Trading begins on CJ50, a multi-dealer Japanese investment-grade index originally

launched by BNP ParibasSeptember 2003 Trac-x dealers launch Trac-x Asia

September 2003 ABN Amro, Citigroup and Deutsche Bank launch iBoxx Diversified, a European

rival to Trac-x trading in both funded and unfunded format

October 2003 11 dealers, including Deutsche Bank, Citigroup, Merrill Lynch and UBS, launch

iBoxx CDX NA IG as a rival to Trac-x North America

November 2003 Trac-x dealers bring Dow Jones on board as an independent administrator for the

index

November 2003 DJ Trac-x launches a European high yield index

April 2004 DJ Trac-x and iBoxx/CDX dealers agree to merge their indices as Dow Jones iTraxx

Europe and Dow Jones CDX NA

July 2004Dealers in Asia relaunch Trac-x Asia as DJ iTraxx Asia and merge CJ50 and Trac-xJapan to form DJ iTraxx CJ


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introductio

manager that receives a new mandate to manage$200 million against a credit benchmark can putthat money straight to work by selling protection

on the index. e firm can then unwind the tradeas it finds its choice of assets to invest in withoutlosing more than a few thousand dollars throughthe bidoffer (see chapter 2).

Liquidity on this scale looks set to transformthe credit markets. In three years time, credit

will probably look more like the equity marketthan the fixed income market, reckons Lisa

Watkinson, global product manager for creditdefault swaps at Morgan Stanley in New York.Developments such as electronic trading, credit

index futures and exchange-traded funds willmake this asset class available to a much broaderrange of investors than those who buy cashbonds.

ere are already some signs of that visionbecoming reality. Electronic trading of indices isnow common between dealers and has reducedtrading costs (see chapter 5), although it maybe some time before traders outside the dealer community have access toexecutable prices on screen.

Several derivative exchanges are working to develop futures contracts based

on credit indices (see chapter 7). ere has also been talk of basing ETFs oniTraxx and CDX, though since these instruments have to be approved by theSecurities & Exchange Commission this could take some time. One official

who has looked into ETFs reckons it could take the SEC 18 months toapprove a product based on a credit derivative index.

The emergence of tradable credit indices coincides with a much broadertrend in the financial markets. Since the launch of the first crude equityindices such as the Dow Jones Industrial Average more than 100 years

ago, investors have come to depend on an ever more sophisticated array ofbenchmarks to understand how their investments are performing in relative

terms.But in the past few years, dissatisfaction with the performance of traditional

asset managers has prompted growing numbers of investors to pursue a newinvestment strategy. Rather than simply hoping to pick a manager thatoutperforms a benchmark, investors are allocating part of their money toalternative investments promising high absolute returns and part of theirmoney to instruments that track the indices.

e same trend is beginning to emerge in credit. What you are seeing

Jared Epstein, MorganStanley: prided ourselvon making a five basis

point bidoffer


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more and more of is the implementation of whathad traditionally been equity-only strategies inthe credit space, says Morgan Stanleys Epstein.

For example, investors are often found usingindex-related products to get their beta and usingalternative investments such as hedge funds to gaintheir alpha.

In the equity market, this barbell approach toinvestment has led to a surge in the popularity ofpassive, index-tracking funds, as well as vehicles suchas ETFs, that have lower management and dealingcosts than traditional investment funds. Somebelieve the same thing could be about to happen inthe credit world.

In the same way that indexation has completelychanged the equity market, I believe that creditderivative indices such as Dow Jones CDX and iTraxxcould transform the credit markets, says MichaelPohly, global head of structured credit trading atMorgan Stanley in New York. For example, thecreation of funds based on credit derivative indicescould revolutionise the way money is managed.

But for all their success, credit derivative indiceshave some serious limitations. And there are plenty of sceptics among thoseinvestment managers bankers would like to recruit to the cause.

Perhaps the most fundamental flaw of the indices is the process by whichtheir constituents are chosen. e most important consideration for deciding

whether a name should be included in iTraxx or CDX is whether or not it isliquid in the credit derivative market.

is feature sets the tradable indices apart from every other index inthe world, where composition is based on some measure of the value of thesecurities outstanding. e liquidity criteria were essential in allowing creditderivative dealers to offer and hedge the product, but it makes CDX and iTraxxa poor benchmark for long-term investment.

Because they are based on liquidity, credit derivative indices do not trackchanges in the value of the credit risk people are holding. Instead they measure

changes in the value of the credit risk that is currently changing hands mostfrequently. is bias towards the volatile is a good thing for anyone who wantsto see changes in credit prices magnified, but it is debatable whether such aproduct can justifiably be called an index.

Furthermore, none of todays credit derivative indices enjoy the samecredibility and transparency as the main equity indices, where committeesspend months debating the finer points of free floats and market value

weightings to be sure that they include the right constituents.

Michael Pohly, MorganStanley: indexation could

transform the creditmarkets


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introductio

At the time of publication, there is no organisation charged with ensuringthat the composition of North Americas CDX indices follows the rules laiddown by its founders. Instead, names are essentially chosen by a handful of

traders from the main market makers meeting every six months over latte anddoughnuts.

In Europe and Asia the situation is slightly different, since the InternationalIndex Company (formerly known as iBoxx) is responsible for administeringthe indices. But even here, composition is decided based on rankings of

names provided by the dealers to IIC, with each dealer ranking the names ithas traded most heavily in the single-name market.

Supporters argue that it would be hard to manipulate such a system. Butinvestors suspect that if a good proportion of the Street is axed on a particularname, the credit will find its way into the index. And there have been more

than a few instances in the past few years think of Enron or Parmalat wherea companys voracious appetite for debt has put almost the entire dealingcommunity long that name.

e other big weakness of todays credit derivative indices though onethat is a much less fundamental problem is that they are liquid only in a fewselect zones of the credit market. For example, most trades are still done to asingle maturity: five years. In 2004 there has been a big increase in 10-yeartrading as investors look up the yield curve to gain extra yield but it is still

In 2004 there has b

a big increase in

10-year trading

Main credit derivative indices, September 2004

Sector Region Numberof names

Five-year midmarket price, bp (3

August 200

DJ CDX NA IG High grade North America 125 60

DJ iTraxx Europe High grade Europe 125 36

DJ iTraxx CJ High grade Japan 50 25

DJ iTraxx ex Japan High grade Asia ex Japan 30 57

DJ CDX NA HY High yield North America 100 381

DJ iTraxx Europe Crossover High yield/

high grade

Europe 30 284

DJ iTraxx HiVol* High grade Europe 30 61.7

DJ CDX NA HiVol* High grade North America 30 127

DJ CDX EM Sovereign Emerging markets 14 272

DJ iTraxx Australia High grade Australia 25 29

* subsets of the DJ iTraxx Europe and DJ CDX NA IG. Source: International Index Company, Mark-it Partners


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impossible to talk about a meaningful credit curve even for the most liquidindices such as CDX NA IG and iTraxx Europe.

It is only in the five-year maturity that there is currently a good two-way

market, and more than 90% of index trading is still done at this maturity.People want to be where the liquidity is, says one credit derivative trader.at is why the five-year is so popular. Everyone wants to sell shorter-datedprotection, but there is no bid.

Credit index trading is still dominated by investment-grade risk in NorthAmerica and Europe. However, the market is steadily broadening to includehigh-yield credit and names from other parts of the world. We will continueto see credit derivative indices expand, believes Morgan Stanleys Pohly. Wehave seen indices launched successfully in Asia this year and since the merger[of Trac-x and iBoxx/CDX], trading volumes for high yield have taken off.

In second-generation index products too, liquidity is concentrated in small

pockets: mezzanine is by far the most liquid index tranche; option trades areconcentrated in three- and six-month expiries.

But it is hardly surprising that some areas of the market are more liquidthan others, especially given the youth of the product. And there is everypossibility that many of the gaps in credit index liquidity will soon be

filled.It is also possible that the indices can overcome the shortcomings of their

basic design. Most indices exist initially as an exercise in price calculationdesigned to demonstrate the general trends in a market. If they meet a need,they are then taken up by the investment community and used as a benchmark.

Finally, bankers will look to fashion some instrument or other that allows firmsto trade the index directly.

By contrast, credit derivative indices have put the cart before the horse.ey have been designed to be traded f rom day one, and it is only now thatthey trade in large volumes that people are thinking about their other potentialuses.

Despite their initial success, transforming indices such as iTraxx andCDX into the credit markets equivalent of the S&P500 or Eurostoxx 50 isa big challenge. It will need many more asset managers, insurers, corporatesand commercial banks to be persuaded of their benefits. And it may requirecredit derivative dealers to give up some trading benefits in favour of greater

transparency and objectivity in portfolio selection.

Lisa Watkinson, MorganStanley: credit willbecome more broadly

available


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the investor viewpoin

Chapter 2the investor viewpoint:benefiting from efficiency

So called real-money investors remain the largest untapped user base forcredit derivative indices, and for credit derivatives generally. ese are

the investment managers who look after unleveraged pools of money forpension funds, life insurers, retail mutual funds and the like, by contrast to theleveraged funds invested by hedge funds and banks.

Typically, activity among real-money investors remains limited to dippinga toe in the market. However, their involvement in CDX and iTraxx indicesis growing, and is starting to include use of the indices for sophisticated assetallocation strategies.

Regulation is one reason uptake has been slow. In contrast to the flexibilityafforded to hedge funds, real-money managers typically face more rigidguidelines, which often prohibit the use of derivatives altogether. Investmentconsultants play a key role in deciding how money should be put to work. A

green light for credit derivatives f rom these consultants would bring many newinvestors into the market, say credit derivative bankers. A further complicationis that where funds are pooled, managers need to get the go-ahead to tradefrom a large number of different accounts.

Klaus Oster, head of credit research at German investment manager Deka,says the firm keeps an eye on credit derivative indices as an indicator, but is notcurrently using them to invest money. It is a mixture of having to clear varioussettlement and valuation issues with auditors, he says, as well as from a legalpoint of view the process of discussing credit derivative usage with our clients.

Nonetheless, growing numbers of real-money managers are receivingmandates to trade credit derivatives, and this has resulted in a discernible

increase in the flow of funds into synthetic indices.Promoters of credit derivative indices say that, in addition to basic hedging

activity, tradable indices offer general asset managers a range of potentialapplications as part of their asset allocation strategies.

e more sophisticated of these involve using credit derivatives indices toexpress sectoral views synthetically on a bond market benchmark. At a simplerlevel, credit derivative indices can be used to put funds to work while waitingfor investment opportunities in the bond market.


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Increasingly dissatisfied with the returns from their traditional investmentstrategies, investors have increasingly begun to look at absolute return strategiesin recent years, causing a sustained flow of money into hedge funds. However,

for the vast majority of the worlds real money, investment continues to bejudged in terms of performance relative to a benchmark.

While credit derivative bankers talk hopefully of their tradable indices oneday being adopted as popular performance benchmarks, to date all the moneyinvested in relative value funds dedicated to credit is benchmarked againstbond indices typically, the corporate component of broad bond marketindices. Merrill Lynch, Lehman Brothers, Salomon Brothers and, in Europe,iBoxx are the main providers of these indices.

ere is a broad trend for money managers to move away from an index-based approach, says Rizwan Hussain, investment-grade credit strategist atMorgan Stanley in New York. But a lot of mandates are still tied to an index

such as the Lehman Aggregate. So managers need ways to replicate thoseindices efficiently.

These broad market indices include sizeable baskets of government bonds,agency debt and structured finance securities in addition to corporatebonds. Clearly, credit derivative indices do not provide such a broad

measure of diversified bond risk, although some analysis has shown that theyare fairly closely correlated with the corporate bond indices offered as part ofbroad market benchmarks.

But a key difference between credit derivative and cash market indices isthat bond indices are highly granular indicators of performance rather than

investment and trading vehicles. Broad market indices include many thousandsof securities, including, in the case of the corporate bond market, all securitieslarger than a certain defined size such as $250 million or $500 million. eircomprehensive nature makes them an invaluable resources for asset managers,

who need to know how the bond market as a whole is performing. And thislack of granularity is one factor that is likely to limit the development ofbenchmarking against credit derivative indices in the foreseeable future.

For real money investors, perhaps the most significant benefit of the likes ofiTraxx and CDX is that they provide a means of allocating new funds quickly.

Credit derivative indices can be a phenomenally useful tool for a creditmanager, says Brian Arsenault, high-yield credit strategist at Morgan Stanley

in New York. In the high-yield market, for example, cash bonds can be hardto come by. With an index like the CDX NA HY you can gain an instant longexposure to the market.

Probably all asset managers agree that in theory credit derivative indicescan provide a means of putting newly invested money to work quickly. But notall managers are happy with using the products in this way.

Axa Investment Managers is one asset manager that uses credit derivativeindices to allocate new money to credit. e index provides a quick way

There is a broad trend

for money managers

to move away from an

index-based approach


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of gaining exposure to the creditmarket for new money coming in toour funds, says Jean Pierre Leoni,

head of credit products at Axa IM.You can make a quick allocation

while waiting for opportunities inthe bond market.

Klaas Smits, head of credit atDutch investment managementfirm Robeco, agrees with thatstatement. e index is very liquidand it is a good way of channellingnew cash flow in and out of themarket, he says. He adds that

the liquidity that is available alsomakes the indices attractive forfund allocation when building up aCDO portfolio. It is a good way toramp up the portfolio, he says. Youcan easily do 50 million to 100million trades, so it is a smarter wayto ramp up. ere is the danger thatpeople will know you are coming if

you are out buying the cash assets.Robeco does not currently make

use of credit derivative indices, butSmits says that the firm is lookingat the instrument closely. We areon the brink of using them, hesays.

But Oster at Deka points outthat parking money in this way brings risks. You can have a discussion over

whether you should use the index or use single-name default swaps insteadof the index, he says. Simply buying the index means you have exposure tonames that you dont want [in the bond portfolio]. So that is a big question.

As we saw with Parmalat, if a name defaults it can have a big impact on the

index.Rosie McMellin, portfolio manager at Deutsche Asset Management in

London, points out that depending on the type of fund, there might be noneed to take advantage of quick allocation through the index. We have largepooled corporate funds here which clients can buy and sell units of, so cashflow is easily invested or offset, she says.

Credit derivative bankers point out that, besides quick asset allocation, theCDX and iTraxx indices can be used by money managers to express sectoral

Jean Pierre Leoni, Axa Iyou can use the indexmake a quick allocatio


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views. ey point out that adding a sectoral overlay to a cash benchmarksynthetically is cheaper, because of the small bid-offer spreads on the derivativeindex, than constructing such a strategy in the cash market. In addition,

sectoral trades can be more easily changed if they are done synthetically, ratherthan by buying or selling bonds.

A synthetic sectoral allocation strategy involves buying the industry basketsof the credit derivative index in proportions that match the cash marketbenchmark. en asset managers apply their overweight or underweight sectorallocations synthetically by buying more or less of the baskets.

However, a synthetic replica index will not track a cash credit benchmarkperfectly. Partly this is because the names referenced by Traxx and CDX areequally weighted, rather than weighted according to market capitalisation,as is the case with cash bond benchmarks. As a result, some companies thatare infrequent borrowers in the bond market are given greater emphasis in a

synthetic index.In addition, the basis between the credit derivative index and the cash

market is subject to movement and distortion, particularly as synthetic indicesare actively traded, and therefore tend to move around more in price than acash index.

Moreover, the theoretical basket of credit derivatives that make up thesynthetic index does not trade perfectly in line with the underlying single-name default swaps. Typically the basket will tighten and widen more rapidlythan the underlying constituents.

Nonetheless, research from investment banks has indicated that a

reasonably strong correlation exists between a synthetic replica index,and the cash index that it is designed to track. For example, analysis by

BNP Paribas of a DJ iTraxx replica of the iBoxx corporate bond index revealeda correlation of 0.89. e sectoral correlation between the two ranged from0.70 for autos to 0.90 for technology, media and telecoms (see table).

However, tracking error is undoubtedly one factor that makes assetmanagers cautious of the synthetic indices. For example, DeAMs McMellinsays that basis risk is a reason why the investment management firm is notcurrently trading credit derivative indices. Our benchmarks are bond indicesand we are not comfortable with the [cash versus synthetic] basis risk, she says.We do, however, have the systems, dealing capability and back office processes

in place to deal them if need be. If a client showed demand, or if we were givena mandate to be managed against a credit derivative index as a performance

yardstick, then it would be relatively easy to put in place.Robecos Smits says that he views synthetic overlay strategies positively,

particularly in relation to the high-yield market. We are in a low volatilityenvironment and if you want to express your positive and negative views,this is a very liquid way of doing so, he says. For example, with high yield,

you cannot buy a small number of bonds to represent the whole market. In

We are in a low

volatility environment

and if you want toexpress your positive

and negative views, this

is a very liquid way of

doing so


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investment grade, you can do that. erefore, if you are positive on high yield,because you are looking at an excess return of plus 100bp, the synthetic indexis a very nice instrument.

However, he adds that in the investment-grade market, spreads arecurrently too compressed to make synthetic overlays an attractive enough

alternative to sectoral allocation via the bond market. e carry is so low, hesays. DJ iTraxx has been trading around the 40bp level, and you have a 1bp to2bp bid-offer spread, so that is one-quarter of 1% of the [bond] coupon that

you are giving up.Expressing a bullish view synthetically entails giving up the cash bond

coupon. However, a bearish trade can be done synthetically while still holdingon to the cash bonds. Say you have a bearish view on telecoms and want toexpress that view, says Paola Lemedica, credit portfolio strategist at BNPParibas. You can sell one or more of your telecom bond holdings. But withspreads this low, reinvestment of the proceeds would be problematic. Another

view would be to keep your cash bond holdings and express a bearish view

through the TMT credit derivative index by buying protection. at way youcan still make a more bearish view, but without having reinvestment risk.

Leoni at Axa Investment Managers says that ease of execution makes creditderivatives indices attractive for taking sectoral views. You can put on tradesquickly, and at a very low bid-offer spread, he says. It is an alternative to themore laborious process of buying or selling the bonds to express a view.

Axa IM is in discussions with the French regulators about going a stepfurther. We are working on providing a fund against an index that is based

Correlation between iBoxx cash index sectors andtheir equivalent DJ iTraxx indices (reconstituted)

Reconstituted DJ iTraxx iBoxx Correlation

Master All Corps 0.89

Corporate Non-financial 0.87

TMTs TMTs 0.90

Autos and auto parts Auto 0.70

Industrials Industrials 0.89

Consumers Consumers 0.82

Energy Energy 0.71

Senior Senior 0.72Subordinated Subordinated 0.80

Source: BNP Paribas


18/51


only on credit derivatives, says Leoni. at gives you greater flexibility forportfolio construction versus managing a portfolio against a broad [cash]market benchmark. For example, you might not want a benchmark with aslarge a weighting in telecoms and autos as the broad market benchmarks, or

you might want to manage your portfolio against an index of European-onlynames in euros, rather than European and US names in euros. US names canmake up 40% of euro broad market [cash bond] benchmarks.

High-grade bond indices: key characteristics

Index Lehman USCorporate

Lehman EuroCorporate

Merrill LynchUS Corporate

Merrill LynchEMU Corporate

iBoxx CorporateMarket value $1.6trn 821bn $1.9trn 1.1trn 653bn% non-financials 62.6 51.7 64.1 48.8 57.6

% financials 37.4 48.3 35.7 51.2 42.4

No of securities 2,510 1,049 3,665 1,352 679

Minimum issue size

(par value outstanding)

$250m 300m $150m 100m 500mSource: Lehman Brothers, Merrill Lynch, iBoxx


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index tranche

Chapter 3index tranches:

from esoteric to flow

The growth of credit derivative indices is based on a straightforwardtrade-off. Dealers agree that they will all trade the same risk on the same

standardised terms as each other. Margins fall as the product becomesmore transparent and more widely traded. But liquidity rises to the point whereincreased volumes and new product development compensate for the incomethat dealers have lost on the core product.

Nowhere is this process more in evidence than in credit index tranches.Once a high-margin spin-off of the main indices, these products havethemselves quickly become part of the flow credit derivatives business.

Credit index tranches have brought standardisation to what was previouslyone of the most customised and esoteric areas of the credit derivative market.

ese instruments are credit default swaps linked to a portfolio of names thatare triggered only if losses within the portfolio rise above a certain threshold.

Like a first-, second- or third-to-default basket trade, tranches provideleveraged or deleveraged exposure to a credit portfolio. In addition to creditrisk they also convey credit correlation risk: that is, the relatedness of theprobability of defaults in that pool.

Just as a credit price implies a probability that the particular name willdefault, so the price of a credit tranche implies the chance that the pattern ofany defaults will hit that particular tranche. If the price of a tranche rises or falls

when the credit spreads on the underlying names remain unchanged, then thefactor that has changed is the implied correlation.

Correlation is embedded in a whole host of credit products, but beforethe advent of tranche trading it was difficult to put a price on it. Standard

index tranches are as significant a development as the indices themselves, saysMichael Pohly, global head of structured credit trading at Morgan Stanleyin New York. ey have for the first time allowed people to observe howcorrelation trades. And they have provided the liquidity that allows people,including credit derivative dealers, to hedge credit correlation risk efficientlyfor the first time and mark their books to market based on real, observableprices.

is benefit of providing an observable market price for correlation is


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particularly important in allowing dealers to recognise profits. Accountingstandards increasingly require banks to use visible market-based parameters formarking their books to market. And the introduction of so-called observability

requirements under GAAP and IAS accounting has been an important triggerfor the rapid growth of index tranche trading.

Standardised credit index tranches might seem arcane to credit outsiders,but they resemble many mainstream credit instruments such as collateraliseddebt obligations (CDOs). Like other credit index products they are creditdefault swaps traded with standard maturities and other terms.

ey provide exposure to a particular slice of credit risk across one ofthe standard credit derivative indices such as DJ CDX NA IG or DJ iTraxxEurope. And the attachment and detachment points of the tranches are alsostandardised.

e tranches are slightly different for each of the main indices (reflecting

the different risk profiles of the indices) but always include a first-loss exposure,and various mezzanine and senior tranches (see table).

e counterparty that buys 10 million of five-year protection on a 3-6%tranche of DJ iTraxx Europe pays an annual premium (around 170 basis pointsin August 2003) and receives payments from the protection seller each timethere is a default in iTraxx that leads to losses in the portfolio of more than3%. If, over the five years, there are 13 defaults on the 125 equal-size names inthe contract and each recovers at 40% of par, the protection buyer will receivethe full 10 million of protection. (But the protection buyer would not benefitfrom a 14th default, since this would take losses above the 6% detachmentpoint.)

e standardised market in index tranches emerged in mid-2003, althoughsome dealers had traded a few tranches based on the indices between themselvesbefore that. e market was quick to take off, with tranches traded on the twoEuropean high-grade indices, Trac-x Europe and iBoxx Diversified, as well ason the North American products, iBoxx CDX and Trac-x North America.

e market received a boost with the merger of the Trac-x and iBoxx

Standard credit index tranches: attachment and detachment points

iTraxx Europe CDX NA IG iTraxx Japan CDX NA HY

First loss 03% 03% 03% 010%Junior mezzanine 36% 37% 36% 1015%

Senior mezzanine 69% 710% 69% 1525%

Senior 912% 1015% 912% 2535%

Super senior 1222% 1530% 1222%

Tranches allow people

to mark their books

to market based on

observable prices


21/51

index tranche

indices in June 2004. With the merger of the Trac-x andiBoxx indices, the volume of index tranches has increaseddramatically, says Chris Boas, head of correlation trading at

Morgan Stanley in New York. It is not uncommon for us totrade $1 billion of index tranches in a week.

Bid-offer spreads have also narrowed sharply followingthe merger. On the highly liquid mezzanine tranches, forexample, bid-offer spreads of between five and 10 basis pointsare now common. As recently as early 2004, the bid-offerspread was usually more than 50bp, although the premiumon this tranche has also halved over the same period.

A lot of index tranche trading has been between dealers.But other counterparties have moved into the market asliquidity has grown. e biggest group of new users are

the fast money accounts hedge funds, prop desks andother outfits that are free to trade in and out of positionsfrequently.

A popular trading strategy has been for hedge funds tobuy the risk that the Street, for technical reasons, is keen tooffload. Most credit derivative dealers have bought a lot ofprotection on senior portfolio tranches through bespoke trades, often calledsynthetic CDOs and CDOs-squared. is gives them a long exposure tocorrelation which, unlike the credit risk itself, has historically been difficult tohedge.

As a result, dealers have been keen to buy protection on junior andmezzanine tranches. is is a good trade for dealers, since it reducesthe overall correlation of their book. And for hedge funds, which are

typically looking for a leveraged investment rather than taking an outright viewon correlation, it has been a profitable strategy as credit spreads have declined.

But the sale of junior tranche protection by hedge funds to dealers has notbeen the only trade in the market. When the index tranche market started, alot of the flow was hedge funds selling 0-3% protection to dealers, says Boas.But since then, the market has become much broader. ere are many differentplayers using the market to hedge, speculate and take long-term views. at isreflected in the increase in volumes and liquidity that we have seen this year

especially.e European and North American markets are seeing rather different

patterns of tranche trading in 2004. is reflects something of a cultural divide.According to traders, whereas dealers European clients tend to think in termsof correlation, US firms are more focused on classic credit market concepts suchas leverage and convexity (sensitivity of the investment to spread movements).

At the same time, Europe has much stronger demand than the US for the kindof bespoke trades that create the Streets long correlation position.

Chris Boas, Morgan Stathe volume of indextranches has increaseddramatically


22/51


e result is thatthe New York dealercorrelation desks tend

to see a greater varietyof trades being done. InEurope we have all donethe same kind of bespoketrades, says a correlationtrader in London. We areall axed the same way andspend our time workingout how to lay off some ofthat exposure. In the USit is much more of a two-

way market.As competition in

the customised portfoliocredit derivatives markethas intensified, particularlyin Europe, the pricingof bespoke tranches hasbecome more aggressive.

at means dealersspend an increasingamount of quantitative

fire power tackling theissue of mapping, thatis, working out howfew trades they can puton through indices andremain hedged in theirstructured credit books.

In terms of bringingtransparency to creditcorrelation pricing, the

index tranche market is already bearing fruit. By far the most noticeable trend

of the first 12 months of trading history is the dramatic decline in impliedcorrelations for the 3-6% and 3-7% tranches and, to a lesser extent, for the 0-3% tranches (see charts).

Indeed, the level of implied correlation for the mezzanine tranche has fallenso low that some dealers have begun to question whether they are using theright mathematics to calculate implied correlation (see box).

But as an observable market, implied correlation is still in its infancy, and itis difficult for traders to put todays numbers into historical context. e short

03% implied correlation

15

20

25

30

AJJMAMFJD

2003 2004

North America (DJ CDX.NA.IG)

Europe (DJ iTraxx*)

Source: Bear Stearns. Indicative mid-market data derived from proprietary models* DJ Trac-x before 27 April 2004

Mezzanine implied correlation

0

2

4

6

8

10

12

AJJMAMFJD

2003 2004

North America (DJ CDX.NA.IG 3-7%)Europe (DJ iTraxx* 3-6%)

Source: Bear Stearns. Indicative mid-market data derived from proprietary models* DJ Trac-x before 27 April 2004


23/51

index tranche

history of index tranches gives us some sense of how correlation trades givenrelatively small moves in the underlying, says Sivan Mahadevan, head of creditderivatives strategy at Morgan Stanley in New York. It does not tell you what

would happen to implied correlation in a more volatile market environmentsuch as early 2002, although there were bespoke correlation products out thereeven then.

If the high-grade index tranche market is still young, there are others thatare even less well developed. But by the middle of 2004, there were growingsigns of tranche trading beginning to take off on indices other than the

European and North American investment-grade products.Perhaps the most developed is the North American high-yield index, CDX

NA HY, originally called Hydi. But tranche volumes on this index remain farbehind those on the high-grade indices. Tranches of the high-yield index havebeen slow to take off because not all the names in the index are particularlyliquid, says Boas. What might work better is to take the high-volatility subsetof the investment-grade index and add double-B names from the high-yieldindex.

Relearning the language of correlation

Correlation is a reasonably straightforward concept, but the mathematicsof turning tranche premiums into implied correlations is fiendishly

complicated, involving processes known as copulas.

A Gaussian copula (that is, one assuming that defaults are distributed

normally) is the industry standard technique for calculating correlation.

But there is no structured credit equivalent of the option markets Black

Scholes model yet a mathematical model that would give traders some

certainty that their trading decisions are rooted in any kind of reality.

Lately, tranche traders have been revising one of the central concepts

in the language of correlation. The idea, which has been dubbed base

correlation by JP Morgan, is that traders should look at the correlation

implied by the entire risk structure up to their detachment point, ratherthan simply think of correlation as an output of the tranche itself.

This approach gives some very different numbers for implied

correlation. And, perhaps fortuitously, it suggests that dealers that

are delta-hedging mezzanine tranches can generally use smaller (and

cheaper) deltas than they had previously employed.

Most correlation traders point out that the way correlation is implied

should not affect their view of the attractiveness of a particular tranche.We

talk to clients in terms of both tranche correlation and base correlation,

says Morgan Stanleys Boas. The important point is to transmit the price

clearly. Clients can then make their relative value decisions more clearly.


24/51


ere have also been attempts to kick-start tranche trading in Asia. Anumber of dealers are now quoting prices on tranches of the DJ iTraxx ex-

Japan index, the DJ iTraxx Australia product and on Japans DJ iTraxx CJ.

But unlike in Europe and North America, there are few dealers with purelyregional books of credit on which they need to hedge the correlation. So far,the purely Asian correlation business has typically consisted of small first-to-default baskets, rather than tranches of wholly Japanese or Asian portfolios.Japanese credits trade so tight that there is not enough spread for customersto justify buying a senior tranche of Japanese names, points out Alex Aram,a correlation trader at Bear Stearns in New York. For the most part, Japanesecustomers have shown interest in domestic names by doing first-to-defaulttrades.

Even so, Bear Stearns is one of a number of dealers that report havingtraded tranches of the various Asian indices.

But whether Asian and high-yield index tranches take off or not, dealersare clearly determined to find some new correlation-intensive productsto provide a stream of profits now that margins in the high grade

tranche business have evaporated.One idea has been to promote standard first-to-default baskets based on

the European and North American indices. Credit derivative dealers beganmaking a market in these instruments in June and July 2004. Although anumber of trades are said to have been completed, early indications are thatthis will remain a small part of the overall index business.

Another idea is to combine correlation and volatility risks by trading

options on index tranches. Again, trades are said to have been completed. isis not yet a product that is quoted in a standardised way but, if the track recordof the tranche market is anything to go by, could one day be traded daily withtight margins in volumes of billions of dollars.

History does not

tell you what would

happen to implied

correlation in a volatile

market


25/51

index option trading

Chapter 4index option trading:waiting for volatility

Of the new generation of credit derivative products that liquid indextrading was designed to make possible, the biggest success story has

been index tranches. By contrast, the development of options on theindices has been less spectacular.

Options are being actively traded on several of the main credit derivativeindices, but the market remains much smaller than the tranche market. It issurprising to think that a 37% tranche of an index is more popular than asimple call option on spreads, says Sivan Mahadevan, head of credit derivativesstrategy at Morgan Stanley in New York. But many investors are not used tothinking about optionality in credit, whereas tranches have been around for aslong as the CDO market. at might be the reason correlation products havetaken off more quickly than those based on credit volatility.

Yet credit optionality is such a natural risk for people to hedge and take a

view on that most people expect options on credit default swaps to be an area ofrapid growth. And after years when credit spread options were much discussedbut rarely traded, the launch of tradable credit indices has certainly been thetrigger for the first trading in credit spread options in any significant volume.

e credit options market has seen tremendous growth in the past 12months, says Greg Tell, North American head of credit options and exoticsat Citigroup in New York. One thing that has really kick-started the marketis the expansion of index product trading. It has given people confidence thatthere is a liquid market out there that allows them to delta-hedge options. Andthe development of index option trading has in turn helped a market in single-name credit options to really get going in the past six months or so.

North America has seen the greatest take-up of credit option trading. Onetrader reckons that in a typical week in mid-2004, some 50 to 60 trades wentthrough across the Street, representing notionals of between $1 billion and $2billion. Europe has lagged some way behind the New York market, but optionsare also regularly traded on the high-grade European iTraxx index.

Take-up of the product has also been relatively strong in Asia, wherereports of three- or six-month option trades on the DJ iTraxx Asia and DJiTraxx CJ are becoming increasingly common. Asia has also seen some trading


26/51


in single-name credit options, perhaps reflecting the longstanding popularityof bond options in the region.

While the first half of 2004 has seen the credit options market broaden

to include a wider number of single names and some more exotic structures,the greatest liquidity is still in options on the indices, particularly the North

American CDX NA IG product. Several dealers in New York report havingtraded options on the high-yield CDX NA HY index, although volumes arestill overwhelmingly dominated by investment-grade risk.

e market trades with European-style options (which can be exercisedonly on their expiry date) and premiums are quoted in basis points and paidupfront. A typical trade size in New York by far the most liquid market is$50 million for options on the index, although trades as large as $500 millionare not unheard of.

e greatest liquidity is in three- to six-month expiries struck close to the

money and linked to a standard five-year credit default swap. Options usuallyhave expiries that coincide with the quarterly standard maturity dates. econtract which the buyer of the option has the right to enter normally hasthe same termination date as a five-year credit default swap starting on theday the option is traded. So a typical six-month option traded on 1 October2004 would give the right to buy or sell 4.75-year protection on 25 March2005 (with the resulting trade terminating on the standard maturity date of 20December 2009).

Index options of up to nine months are known to trade, but beyond thisexpiry, the market hits a snag. Traders are unwilling to take a view on the valueof the index beyond about six months, because nobody knows for certain what

names will be included in the new version of the index at each roll date.What makes the index so suitable for options trading is its liquidity,

points out Tell at Citigroup. If you trade an option on a swap with a tenorthat doesnt trade actively, for example 12 years, then you lose that liquidity. Onthe other hand, trading a long-dated option on a when-issued future index isdifficult since there is no real economic way to price the effect of future rolls.

e fair value of the index may increase or decrease depending on which namesare included. Single-name CDS options dont face this issue, so we are morelikely to see longer-dated options in that context first.

One factor that may have held back the development of the credit optionsmarket is the low level of

actual (or realised) volatilityin the credit market in 2003and, especially, in 2004. As

with any option market,credit options are worthmore to the buyer the morespreads jump around.

As a result, there have

Europe has lagged

some way behind the

New York market,

but options are also

regularly traded

Volatilitys tower of Babel

Right to buy protection Right to sell protection

= payer = receiver

= put option on credit risk = call option on credit risk

= call option on credit protection = put option on credit protection


27/51

index option trading

often been more people willingto sell options than buy them. etypical flows in the options market

have been from sellers of optionslooking for yield. For example, acounterparty that believes spreadsare unlikely to widen significantlyin the near future and wants togenerate some income from theoption premium would sell theright to buy protection. However,some traders say there has been ashortage of natural option buyers,given the current market environment.

ose flows can be seen in the price of credit options expressed in terms ofimplied volatility (see chart). e volatility implied by the price of options onthe CDX index has declined from the low 50s at the end of 2003 to below 35%in July 2004. By some calculations, implied volatility has occasionally dippedbelow 30%. at is a big fall even taking into account the decline in realised

volatility over that period. In other words, sellers of options have made a killingin the early part of 2004.

e two months after July, however, have seen a slight uptick in impliedcredit volatility, suggesting that the market may be turning.

But despite the market moving in one direction for most of its existence,traders say this is far from being a one-way market. One of the most exciting

things about this market is that there are real two-way flows and people areusing the product in different ways, says Tell at Citigroup. You might have ahedge fund putting on and delta-hedging a pure volatility trade on one side,

while on the other side an asset manager might be using an option to express afundamental, long-term credit view.

In the first half of 2004, traders say the breadth of option trading strategieshas increased considerably. For example, people now trade single-name optionsagainst index options and different expiries against each other.

Some of the most active traders of credit default swap options are hedgefunds and other so-called fast money accounts. ese firms have emerged assome of the biggest users of the market, in both index option and single-name

option trading.Another important client for credit option market makers are their

colleagues who run the correlation books at the big dealers. Correlation traders,who trade products such as bespoke portfolio tranches, nth-to-default basketsand index tranches (see chapter 3), spend a lot of their time hedging againstcredit spread movements. Often this can be done most efficiently using optionson indices and options on single names.

A lot of the flow in the credit options market is from people hedging their

Implied at-the-money volatility (%)North America (CDX NA IDG)

30

40

50

60

AJJMAMFJD

2003 2004

PayReceiv

Source: Bear Stearns. Indicative mid-market data derived from proprietary models


28/51


correlation books, says Chris Boas, head of correlation trading at MorganStanley in New York. Options on credit derivative indices can be an effective

way of taking on or reducing credit convexity.

Credit index options have become a core part of most dealers creditderivative business, with around a dozen firms making a market in the productin North America and a slightly smaller number in Europe. Some dealers tradethe product alongside tranches from a general exotic credit derivatives desk.However, as the market grows, there is an increasing trend for firms to set upunits dedicated to options.

A number of dealers are beefing up their option trading businesses inpreparation for a surge in volumes. Many traders believe that an uptick inactual credit market volatility would bring home to many potential users thebenefits of option trading. It is hard getting people to trade options whenthere is no volatility in the market, complains one banker.

If this market takes off as many believe it can, trading straight optionson the indices would not be a big money spinner for dealers. Unlike creditcorrelation, the mathematics of volatility are well understood, so there is littlecompetitive advantage to be gained by developing a more sophisticated modelfor hedging index options.

Instead, index options are set to become the basic workhorse of the creditvolatility market, a low-margin, highly liquid instrument that can be onebasic component of multi-leg option trading strategies and a hedge for morecomplex instruments (see box).

Index options are set

to become the basic

workhorse of the credit

volatility market

The next generationCredit derivative dealers have spent a lot of time recently looking for the next generation of credit

options and option-embedded products that can be traded. Top of the list for many are options on

index tranches, a product that already trades on an occasional basis.

Another option-related product is the constant maturity default swap, a credit default swap with a

premium that floats in line with the prevailing spread of the underlying credit. For example a five-year

constant maturity default swap on Ford might pay a premium set as a proportion of the then five-year

Ford credit default swap price at each payment date.

In order to hedge this product, traders need a good handle on the credits forward curve. The value

of the instrument is linked to the credit risk of the underlying not just within the next five years, but at

points between five and 10 years.For this reason, traders expect the product to be limited to credits that can be expected to remain

liquid in the medium term, and where there is a visible credit curve. That means the constant maturity

default swap is likely to be traded mainly on liquid single names rather than on the indices.

Nevertheless, constant maturity default swaps have been used for indices. Morgan Stanley for one

has traded a portfolio-linked constant maturity default swap linked to the current version of the Trac-x

Europe index.


29/51

trade execution

Chapter 5trade execution:

the pursuit of liquidity

The goal of providing better liquidity in the credit market has alwaysbeen at the heart of the credit index project. By 2002, banks had spent

several years touting the benefits of credit derivatives to a wide group ofpotential users such as corporates, asset managers, hedge funds and insurancecompanies. And although the market experienced impressive growth in theearly years of this decade, use of the product remained limited to a small sectionof the financial services industry, chiefly banks of one kind or another.

One of the biggest obstacles to market access for many potential users wasthe credit derivative markets lack of liquidity. Consequently, one of the mostnotable features of the new generation of credit index products that sprangup in 2002 and 2003 was that their sponsors emphasised a commitment tomaking tight two-way markets.

Of course, promising liquidity is different from delivering it, and it has

taken a while for investors to be comfortable with the idea that liquidity will bethere when they need it most.

Certainly in the early days of the market, when credit derivative indiceswere provided by single sponsoring banks, it was harder to persuade investorsthat they could rely on good execution at all times. However, even after themarket moved to a consortium-based approach to market making, it has takentime for investors to reach a point where they can assess liquidity confidently.

Until recently, for example, credit derivative indices had not been tested inthe context of an investment-grade default. at changed at the end of 2003,

with the default of Italian dairy products maker Parmalat.Analysis of the markets that were being made when Parmalat blew out

suggest that default swap indices passed the test comfortably. e Dow JonesTrac-x Europe index, which included Parmalat, traded at a bid-offer spread ofthree basis points or less throughout the debacle. at compares with the 2bpmarkets that were typically being made in the rival iBoxx Diversified index,

which shed the Parmalat name at an earlier rebalancing.Parmalat demonstrated to portfolio managers that they can buy protection

in large size at any time in the market, noted Yassir Benjelloun, a credit indextrader at BNP Paribas, adding that BNP Paribas was making between 1bp


30/51


and 3bp markets in Dow Jones Trac-x Europe, in sizes up to 100 millionthroughout the meltdown in the credit. Trac-x Europes other main sponsors,

JP Morgan and Morgan Stanley, provided a similar commitment to liquidity

during the Parmalat blow-out.UK investment management firm Henderson Global Investors was one

investor that was active in the indices around that time. We were using theTrac-x corporate and Trac-x Europe indices to give us a bulk hedge, saysportfolio manager Daniel Beharall at Henderson. Parmalat had blown outas well as Adecco but liquidity was superb. It was a very satisfying hedge. Wemade money on the short side three months running.

Henderson is not alone in delivering that verdict. Indeed, all the anecdotalevidence suggests that investors today are uniformly satisfied with the level oftrading commitment they see in the market.

From the earliest days of the market, liquidity and transparent prices have

been the great selling points of the new indices. Morgan Stanley, for example,committed itself to making a 5bp market in its seminal Synthetic Tracersindex, which it introduced in the US market in April 2002.

However, the real collapse in bid-offer spreads began around the endof 2003, as competition between the rival Trac-x and iBoxx indices becameintense and as expectation grew that the two products would end up beingmerged into a single suite of super-liquid indices.

From the 3bp or 4bp markets that were previously the norm on the maininvestment-grade indices, bid-offers were whittled down to 1bp or even zerobasis points in some cases.

A bid-offer spread of 0.5bp to 1bp has continued to be the norm on

the main indices, followingthe creation of the combinedDow Jones CDX and Dow

Jones iTraxx brands (see chart).Dealers say that it is not unusualfor trades to get done in largesize on a 0.5bp bid-offer. Youdo see markets of 0.5bp on 100million, says credit derivativestrader Haider Ali at ABN Amro.It is phenomenal.

e high-volatility indicescan also trade on very tight bid-offers. For example, markets inthe DJ CDX North AmericaHiVol, which has been tradingin the 130bp region, have beenas tight as 0.5bp in mid-2004.Meanwhile, the DJ iTraxx

Parmalat demonstrated

to portfolio managers

that they can buy

protection in large size

at any time

JP Morgan iTraxx/Trac-x Europe bidofferspread (bp)

0

1

2

3

4

5

AJJMAMFJDNOSAJJMAMFJDNOS

2002 2003 2004

Source: JP Morgan


31/51

trade execution

Crossover has been trading inthe 300bp region on bid-offerspreads as tight as 4bp.

Liquidity in some of thesecond-generation indexproducts has been almost asimpressive as in the main indices.Most notably, tranches of theinvestment-grade indices haveseen a sharp compression in bid-offer spreads since they begantrading in mid-2003. Accordingto JP Morgan, bid-offers on the0-3% tranche of the European

high-grade index has come infrom between 6% and 8% inlate 2003 to less than 1% by mid2004. e biggest increase inliquidity coincides with the merger of the Trac-x and iBoxx products.

As liquidity has increased, and as volumes have grown and dealing costshave declined, credit derivative indices have begun to follow other commoditiesaway from a voice-intermediated, negotiated market towards a model wheretrading is done at the click of a mouse.

ere is not yet an exchange-traded credit index contract (see chapter7). However, in the interdealer market, a good proportion of volumes have

migrated from voice brokerage to executable broker screens.Only large players in the credit derivatives market have direct access to these

systems, of course. But around 20 dealers, for example, are using CreditexsRealTime screen. And traders point out that customers of these banks shouldbenefit from the increased interdealer liquidity, as dealers compete to offerinvestors and hedgers good execution.

Widest and tightest bidoffer spreads, July and August 2004

bp % of premium

High Low High LowDJ iTraxx Europe 0.6 1.0 1.4 2.3

DJ iTraxx Credit Japan 0.5 0.75 2.0 3.

DJ iTraxx ex-Japan 1.0 2.0 1.7 3.3

DJ iTraxx Hi Vol 1.75 2.25 2.5 3.

DJ iTraxx Xover 4.5 7.25 1.5 2.4

JP Morgan iTraxx Europe 36% tranchebidoffer spread (bp)

0

10

20

30

40

50

60

70

80

AJJMAMFJDNOS

2003 2004

Source: JP Morgan


32/51


Brokerage firms have offered a variety of different platforms for creditderivative trading. ey range from pure screen-based systems to hybridplatforms incorporating both electronic and voice-brokered execution (seebox).

T

he relaunch of Creditexs electronic trading platform was the catalyst forthe move into screen-based trading. Creditex was established in 1999as an online trading platform for single-name credit default swaps, but

switched to more of a conventional voice brokerage role after single-namee-trading failed to take off. But the firm was well positioned to launch anelectronic platform for indices when the product became sufficiently liquidto allow electronic trading. Creditex set up an e-trading platform specificallyfor European and US investment-grade indices, known as RealTime, early in2004, and has subsequently added single-name trading as well.

e platform made an immediate impact. Liquidity shifted overnight,says one index trader. e switch was most pronounced in the North Americanmarket where, at one stage, 99% of interdealer index trades were being executedusing the RealTime screen, according to traders. In Europe the ratio of screen-based trades to voice was put at 10 to one.

One obvious reason for the success of the system was that it reduced dealersbrokerage costs. Execution on the Creditex screen costs $500 for a standard$25 million trade. at compares with the $2,500 per trade that dealers werepaying for voice brokerage before the Creditex screen was launched.

In response, other brokers quickly cut their voice broking fees to bring themclose to the price Creditex was charging for online execution, which prompted

volumes to swing back to voice brokers to a significant extent, especially inNorth America.

Horses for courses: varieties of broker screen

E-trading system Trades are executed exclusively or primarily on screenwithout any interaction with the voice broker; brokerage firm Creditex is

currently the only example of this type of trading platform.

Hybrid system Trades are executed on screen but with the option of

executing trades through the voice broker. This hybrid alternative to

pure screen-based trading is being offered by brokerages such as GFI.

Price-only screen Traders have the ability to enter and remove prices

on screen but execution is done by voice through the broker. This

interactive but non-executable approach pre-dates the move to

electronic trade execution.

Credit derivative

indices have begun

to follow other

commodities away from

a voice-intermediated,

negotiated market


33/51

trade execution

Some traders suspect that the cheapest formof brokerage will always win out, regardless ofthe technology. But others see different forms of

execution being used for different types of trade.Mazy Dar, Creditexs head of electronic

trading platforms, puts the case for the screenas follows. ere is a role for electronic tradingand a role for voice, he says. e electronicsystem provides complete price and tradetransparency as well as operational efficiencies.

e electronic system allows traders to easilyplace live, actionable prices, as well as receiveautomated end-of-day trade confirmations,

which eliminates some of the risks associated

with the trade reconciliation process.For some traders, certainty of execution has

become as big an attraction as price for thescreen-based trading systems, since the dealerthat posts a price is committed to completingthe trade at that level.

Traders say that going through a voicebroker, by contrast, can be a frustrating process,

with trades sometimes falling through at the lastminute. Reliability of pricing is a reason for using the screen, says a trader at alarge US bank in London. With Creditex you can look on the screen and you

know you can trade those prices. at is different from being told by a brokerthat the trade is there and then have them say to you I call you off right as

you are speaking to them. On the other hand you do not get the same marketcolour as you do going through a voice broker.

Although Creditex has gained first-mover advantage in the e-tradingspace, the development of platforms that combine voice and electronic tradeexecution are a new threat. GFI, which has traditionally been the biggest voicebroker in credit derivatives, has taken the lead in this area, although other firmssuch as Prebon are also working on hybrid screens.

GFI, however, has been the first to launch a combined voice and actionableelectronic screen, called CreditMatch. e system has been launched initially

for single-name trading, but with the expectation that index trading will beadded.

We were advocating hybrid screen and voice execution five years ago,says Michel Everaert, global head of sales and marketing at GFI. But the lessliquid the market is the more sensitive price dissemination is. e key phrase isprice impact. If you want to do a very large trade, say $100 million, on screenthe price will have dropped and dropped again by the time you have completedthe trade. On the other hand, if you want to do a standard size and there are 20

Michel Everaert, GFI: thkey phrase is price imp


34/51


or 30 buyers and sellers and the market is pretty set on where the price is, therecan be an advantage in advertising to as many people as possible by putting iton the screen.

For firms that are customers of the big dealers, arguments over whetherinterdealer trading is done electronically or by voice brokerage may seemsomewhat irrelevant. But the transparency and liquidity of the interdealermarket has a direct bearing on the dealing costs that they pay.

For the many asset managers, hedge funds and other users of indexproducts, the biggest issue is not todays bid-offer spread, but thelikelihood that the market will still be liquid when they want to get out

of a position.A truly liquid interdealer market is a good indicator that liquidity is here to

stay. But it is worth remembering that credit derivative indices such as iTraxx

and CDX have emerged in a benign market environment. e only creditevent that has affected a high-grade index is that of Parmalat. And that default

was treated by the market as an idiosyncratic event: the Italian companysbankruptcy had no discernible impact on the spreads of other companies.

e real test of the liquidity of the credit derivative indices will come whencredit experiences its next bout of market-wide volatility. It will perhaps onlybe once the market has suffered an event such as the failure of a big marketmaker, a series of related defaults or an external shock such as the terror attacksof September 2001, that credit traders can be sure that the index market hasreally achieved the deep long-term liquidity seen in markets such as equitiesand foreign exchange.

iTraxx and CDX have

emerged in a benign

market environment


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infrastructure challenge

Chapter 6infrastructure challenges:coping with the volumes

Credit derivatives are still a relatively new market that lags well behindother, more established asset classes when it comes to operational

efficiency. Many in the market have long worried about its sometimesrudimentary architecture. e biggest problem we are facing right now isscalability, said a credit derivatives trading head in late 2002, expressingconcern about the back office failing to catch up with the increase in volumesthe dealer was experiencing.

But the infrastructure headache was about to become a lot more painful.e advent of credit index trading in 2003 has introduced a new dimension ofcomplexity to the business. Even more important, the sheer volume of indexand index-related trades threatens to clog up a system that has evolved onan ad hoc basis, and is still largely geared towards bespoke OTC contractsbetween large banks.

at makes it essential for dealers and their customers to streamline andintegrate their processes if the business is to continue to grow. Without muchgreater use of automation and common standards, bankers warn, the market

will become clogged with the backlog of unprocessed trades and the resultingerrors could do lasting damage to its credibility.

Already, some estimate that index volumes represent at least one-third ofall credit default swap trades. e speed of uptake has brought about a flurryof infrastructure developments, and some of the challenges although by nomeans all are now beginning to be met.

Industry association Isda noted in its latest operations benchmarkingsurvey, released in June 2004, that data for less than a quarter of credit

derivatives trades reached the back office within one hour last year, and somedeals had still not been received by the back office by the following day.

Isda advocates adoption of financial products mark-up language (fpml) as acommon data standard for institutions to exchange information electronically.

And the setting of an fpml data standard for credit derivatives last year haspaved the way for several initiatives designed to improve trade processing.

e most significant of these are confirm-matching services launched by theDepository Trust & Clearing Corporation (DTCC) and Swapswire. Both use


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fpml to receive trade details from counterparties and compare them (in the caseof DTCC) or get them affirmed (in the case of Swapswire) see diagram.

ese services combine the processes of verifying, confirming and legallyexecuting trades into a single event. If confirmed manually by fax andtelephone it takes on average 21 days to confirm a transaction, according to

Isda, whereas DTCC says that over half of all trades on its system match oninitial submission, meaning, theoretically, that they can be confirmed withinminutes.

So far, DTCC has signed up about 40 users, including all the major dealersand a handful of end-users. It introduced a schema to enable it to match indextrades in June, and banks will begin using the service shortly, once a standardindex template is finalised.

But some estimates suggest that under a quarter of all default swap trades arematched by DTCC or Swapswire. If only one party to a transaction subscribesto the service, it must still be confirmed manually. Not surprisingly, the biggerdealers are promoting automated confirm matching. Were encouraging all

our clients to get on DTCC, says Jared Epstein, managing director and headof investment-grade credit derivatives trading at Morgan Stanley in New York.

As buy-side players are estimated to account for up to 40% of index trades, farmore than the current handful of hedge funds need to sign up to DTCC andSwapswire to create critical mass.

Straight-through processing is a rarity among smaller institutions such ashedge funds and regional banks. According to Isdas benchmarking survey, nosmall firms used fpml at all last year, and only 8% planned to do so this year.

Confirm affirm versus confirm auto-matching

Affirm Auto-match

Counterparty 1 Counterparty 2

Resolveexceptions

Affirm trade detailsIndicate exceptions

Submit trade

Submit trade

Affirm trade detailsIndicate exceptions

Broker Affirm

Counterparty 1 Counterparty 2

Resolveexceptions

Receive matchesReceive exceptions

Submit trade

Submit trade

Receive matchesReceive exceptions

Broker

Matching

Broker

Source: Isda


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For the largest institutions, that figure was 80%. ey have to balance the costversus the size of the problem, says Michel Everaert, global head of sales andmarketing at inter-dealer broker GFI in London. e alternative is taking

an email or fax and inputting the data manually. is takes time and there isa risk of errors. But if you only type in two or three trades a day, the cost ofautomating the process may outweigh the benefits.

And those costs can be significant. For a large bank to invest in theinfrastructure necessary to automate all possible processes, expenditure canreach 1 million, not including personnel time. With DTCC the mosteffective way is to plug it into your server directly, but this can involve somerelatively expensive investments and the timeline can be six weeks to twomonths, depending on your IT capacity, says Epstein. For smaller firms,however, DTCC is available as a web-screen user interface or file transferprocess, removing the need for major IT investment.

Implementation also depends on the banks existing infrastructure.Goldman Sachs is one of very few institutions to interface with both DTCCand Swapswire. We find fpml applications relatively easy to integrate with,says Mel Gunewardena, managing director and global head of derivativesoperations. Over the last few years, we have invested in building a real-time,back-to-front, fully integrated operating infrastructure across all derivativeproducts. Once a trade is input, it automatically feeds all parts of risk,operations, collateral and client reporting.

But many smaller firms are struggling to cope with the complexities ofautomating trade processing. If you have different systems involved, its

very difficult to achieve straight-through processing, says a source atone second-tier bank. And without STP there is a lot of manual input. We are

working on a system for credit default swaps that will connect via middlewareto our existing systems, and will also enable us to use DTCC.

With the growth of volumes and liquidity in credit indices, a new feature ofthe credit derivatives market has emerged. For the first time since credit defaultswaps emerged some 10 years ago, trades are now being executed in significantnumbers electronically though, for the moment, only between big dealers.

e shift towards electronic trading, through broker platforms such asCreditexs RealTime and, more recently, GFIs CreditMatch (see chapter 5),has brought an even greater need for automation and standardisation.

Creditexs system uses fpml to transfer trades from the platform to thedealers back office. Important steps that make e-trading possible are theselection of reference obligations ahead of trading, and the use of standardisedterms such as standard maturity dates. e next stage for Creditex is to makeapplication program interfaces (APIs) available to link directly to banks ownsystems. Looking ahead a couple of years, dealers would be able to inputtheir trade parameters into their own trading model and that information

would be posted directly from their system to Creditex, says Ben Lis, deputy


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chief technology officer at Creditex. Until now, trade volumes havenot made this worth doing, but at some point, it could become animpediment to the growth of the market.

In addition to launching electronic trading platforms, some of thelargest credit derivative inter-dealer brokers have switched to usingfpml to exchange information with dealer clients.

Creditex, for example, began offering deal verification in fpmland an fpml trade feed earlier this year. e latter provides real-timenotifications into a banks trade capture system for all default swapand index trades both e-traded and broker-assisted executedthrough Creditex.

Garban currently sends fpml confirm details to Swapswire onbehalf of four banks, and is currently the only broker that has signed

up to the service. ere is less scope for brokers to work with DTCC, since it

matches details received directly from both counterparties. On Swapswire, bycomparison, only one party which may be the broker submits trade details,and these are then affirmed by the counterparties.

Prebon plans to join Swapswire later in 2004, and currently sends tradenotifications in fpml to one major bank client. But its preferred option is atrade notification service established earlier this year by a consortium of around40 brokers, in which the broker inputs trade details and sends them to bothdealers via the internet. Straight-through processing is not a competitiveadvantage, says Tim Dennis, head of business development in the technologygroup at inter-dealer broker Prebon. e broking industry should use it as acustomer service, so the consortium approach is the right one. e client has

just one pipe to receive notifications, rather than an individual pipe for eachbroker. He claims this is the cheapest option too, costing from 5,000 a year,so it doesnt exclude smaller banks and can also be used for any asset class.

The hybrid screen-and-voice PrebonEdge trading platform is a web-based system. e customer downloads the application via a web link.In theory its very simple. Its only security that makes it an issue for

the banks, as they need to successfully deploy it through their firewalls, saysDennis. e platform was developed by software vendor Trayport and providesan API enabling trades to be sent directly to banks back-office systems.

Trayports trading platform is not just available to brokers. Sales manager

Richard Klin says banks could also deploy the system which introducedcredit default swaps and indices in July to their clients. Klin is adamantthat e-trading is the way forward for bank-to-customer trading, even if dealsmust actually be executed by telephone or instant message. Trades can beautomatically passed to the mid- or back-office system, so the trader doesntneed to input data. is gives traders more time to do deals, he says.

ere is little sign yet, though, that banks are investing in e-tradingsolutions for their customers. Most post Bloomberg pages and runs on their

Ben Lis, Creditex: dealersown trading model

inputs will be posteddirectly to Creditex


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client website, and supplement these with price updates by email, whilesome offer clients real-time information on all their positions, transactionsummaries, payment and settlement details and even analytics. But trades are

still actually executed over the phone. Weve talked about putting up pricesthat are executable, says Mike Srba, head of European corporate credit tradingat Royal Bank of Scotland. Some banks have tried it, but the feedback hasntbeen that positive.

Market participants are confident, however, that indices will, in future,be traded on exchanges or used as the basis for futures contracts (see chapter7). Within the next few years this will happen, and we are in the processof figuring out how it will impact on our business, says Morgan StanleysEpstein. It will definitely change the way we trade, how we book trades, andhow we interact with clients.

Some software providers are also preparing for this eventuality. John

Mooren is business solutions director at Front Arena, a straight-throughprocessing system owned by SunGard. He plans to be ready if exchanges suchas Eurex and the Chicago Board of Trade (CBOT) begin trading futures basedon iTraxx. Our customers wouldnt need to use the application supplied byEurex or CBOT, says Mooren. ey would be able to send a quote or orderautomatically to market and look at the market in Front Arena, then hit a priceif they wanted to trade.

Front can already interface with Creditexs e-platform and send data toDTCC and Swapswire. Index trading provides a good sales opportunity forsoftware suppliers such as SunGard, as it is bringing credit derivatives tosmaller players that might not have

Documents

Credit Flux Credit Index Trading 2004