The credit derivatives market witnessed stellar growth last year, up 48% in the first half of this year and 128% year-on-year to June, according to the International Swaps and Derivatives Association. Despite several credit scares and the increased role of hedge funds worrying some market participants and regulators forecasters are speculating another banner year ahead. Estimates hover around 50% growth for each half of 2006 and 2007 or 120% overall.
The growth in credit derivatives trading "has been very much a positive in terms of liquidity and the number of names that are traded and the ability for credit derivatives to provide an alternative market for credit as contrasted to the corporate bond market," says Roger Merritt, a credit derivatives analyst at Fitch Ratings.
New products, while still tiny in number and volume compared to single-name credit default swaps, offer some interesting options, such as the development of credit derivatives written against structured finance bonds, including residential mortgage securitizations, which the ISDA has issued standards for.
"You're going to see more and more use of use of credit derivatives for synthetically-referenced structured finance assets," Merritt says. "That really represents the new asset class."
There is also a developing market in CDS tied to secured debt and preferred shares, according to Michael Fuhrman of inter-dealer broker GFI Group, which completed what he called the first CDS referenced to a loan in October.
Expect credit derivatives users to continue to diversify, as well. "There are even some buy-side mutual funds involved in this market as well, and now there's talk about pension funds using credit derivatives as well," Fuhrman notes.
Hedge funds, now accountable for about 30% of the trading volume, are responsible for much of the growth. Their presence has helped make the market more liquid, and, in the search for higher yields in the low interest rate environment, they provide an avenue for spreading risk in a sector where it is highly concentrated.
"The growth in activity over the last year and a half is largely driven by hedge funds," says Fuhrman. "They've become the dominant force in the market in terms of trading activity." Merritt agrees, adding that the role of hedge funds as "trading participants in the market an important milestone in 2005." Still, there are concerns, among them hedge funds' vulnerability to market events, exemplified by the collapse of Long-Term Capital Management following Russia's devaluation of the ruble and moratorium on more than $13 billion in Treasury debt in 1998.
Some big losses notwithstanding, the credit derivatives market withstood several big tests from the auto industry this year. Detroit giants Ford Motor Company and General Motors, along with their finance arms, saw their debt ratings cut to junk this year and auto parts maker Delphi filed for bankruptcy in October. Those three names were the most actively traded credit default swaps in the U.S. this year, topped by the General Motors Acceptance Corp., according to GFI.
"On the whole, the market has proven itself to be fairly resilient and fairly adaptive in coming up with new settlement protocols to address new, and in some cases very large, defaults," Merritt says of Delphi. When the Troy, Mich.-based manufacturer filed for bankruptcy in October, there was reportedly more than $20 billion in outstanding credit derivatives on the company, compared to only $2 billion in outstanding debt.
"The biggest borrowers tend to be the most active names in the CDS market," Fuhrman explains, and the ratings actions only amplified it. And with big auto industry names still in turmoil, Fuhrman expects to see the same names topping next year's CDS activity tables.
Scares such as these increased fears that the market was unstable, leading the Federal Reserve Bank of New York to ask 14 of the biggest banks in the market to reduce the number of unconfirmed trades in their books. The players are aiming for a 30% reduction by Jan. 31, in time for a February report to the Fed. The banks have also agreed to cut the backlog in half, from their September levels, by April 30, and to increase automatic trade processing.
"The issues with the back-office settlement of transactions and the inability to identify counterparties and to document transactions represent an overhang on the market and an area of concern for the banking regulator in particular," Merritt notes.
How the market, particularly hedge funds, use these new products, and the effectiveness, or lack thereof, of new settlement processes, will play a big role in the coming year. While growth seems certain, stability may be tougher to nail down.
