IFR’s recent credit derivatives roundtable came soon after 14 leading dealers had been called in to a meeting with regulators from around the world hosted by New York Federal Reserve president Tim Geithner. The dealers were summoned to explain how they planned to remedy problems associated with the explosive growth of the sector, and participants in our roundtable had varying views on whether the industry is taking the right approach tactically and strategically to issues such as reduction of the default swap confirmation backlog and unnotified assignment of trades.
Delphi had also recently filed for bankruptcy and the roundtable participants discussed the issues surrounding a move towards cash settlement of credit derivatives – a matter that is taking on some urgency as market participants work out how many thousands of contracts they have outstanding that refer to the failed auto parts firm.
The credit correlation mini-crisis of April and May also remains fresh in the memory of all market participants – not least those caught off guard by the relative movement of prices of the equity and mezzanine tranches of synthetic portfolio trades.
The roundtable attendees discussed the lessons that were learned from the correlation market disruption and the subsequent reworking of credit derivatives products.
They also addressed the potential opportunities and pitfalls of developing new markets for credit derivatives, including default swaps and synthetic portfolios based on asset backed securities, preferred shares and loans.
All major market participants expect growth in these sectors, but issues such as the ‘soft’ triggers for swaps that are based on new references have not been finally resolved.
Nor was there agreement on the issue of futures contracts based no credit derivatives. Eurex seems likely to forge ahead with a futures contract based on the iTraxx index in the early part of next year. The roundtable attendees were divided on whether there will be much real demand for futures, however. For professional credit investors and traders the CDX and iTraxx indices already offer exceptional liquidity and minimal trading costs. For neophyte investors and hedgers, by contrast, the difficulties in observing credit prices in a manner comparable to equities could act as a deterrent to credit futures use.
The roundtable attendees all agreed that the sharp growth trajectory of the credit derivatives market is set to continue.
But they had diverging views on the possible effect of a serious credit event – like a bankruptcy filing by General Motors.
The credit derivatives market has so far survived all the challenges it has faced - from the Enron, WorldCom and Delphi bankruptcy filings to confused correlation movement and operational backlogs.
A failure of one of the auto giants would be the biggest test yet faced by the market, in both operational and confidence terms. It could cause serious dislocation in the short term, or simply push spreads out and prompt another wave of structured credit product sales by increasing the returns on synthetic portfolio trades. 2006 may well tell.
