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credit index trading


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credit index trading





The Creditux inside guide to credit index trading

Written by Lisa Cooper, Euan Hagger & Michael Peterson Edited by Michael Peterson Design & production by Miles Smith-Morris & Roger Thomas

Published by Creditux Limited 63 Clerkenwell Road, London EC1M 5NP, UK www.creditux.com Creditux Ltd, September 2004

ONE introduction: a different kind of index the investor viewpoint: beneting from efciency index tranches: from esoteric to ow index option trading: waiting for volatility trade execution: the pursuit of liquidity infrastructure challenges: coping with the volumes the futures of credit indices: deeper, broader, cheaper Glossary 5 TWO 11










41 47

f Creditflux C

news and analysis of the global credit derivatives market

Where do you learn about developments at the cutting edge of credit?

swaps London trading desk The inside guide to portfolio credit March 2004
February 2004

GM seeks alpha Recovery swaps set to explode May 2004 through credit Wachovia sets up April 2004

Morgan Stanley plans credit index floater

February 2004

Agencies act on Agencies scupper HVB spin-off plans CDOs-squared January 2004 December 2003 Volatility flight Primus looks to single-tranche risk trading takesApril 2004 February 2004 Nikko loses CLNs case against UBS March 2004

MBIA drops plans for super-senior hedge January 2004

JP Morgan trades equity hybrid CDOs February 2004

A market in flux needs a fast and reliable source of news and analysis. Subscribers rely on Creditflux to explain 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, Creditflux has quickly established itself as the pre-eminent reference source for this fast-growing market. Through monthly print issues, weekly online updates of breaking news and market data, and one-off in-depth reports, Creditflux includes: 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 swap prices, implied correlations and volatility, defaults and rating actions Creditflux is available exclusively to subscribers, who receive 12 print issues a year as well as unlimited access to www.creditflux.com. Subscribe today: go to www.creditflux.com and choose subscribe.

Chapter 1 introduction: a different kind of index

hen 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. Earlier attempts to create liquid instruments that tracked the investment-grade credit market, such as bond funds, were hampered by a lack of liquidity and by the tendency of these products to develop their own technical forces, pushing them out of kilter with the index. With Tracers, as with ETFs, the price of the instrument would be kept in line with the index it is supposed to follow by arbitrage. Investors could, at any time, redeem their holdings and receive all the underlying bonds. Like ETFs in the equity markets, it was hoped that Tracers would become a highly liquid trading instrument, and channel large waves of investment into the credit market. Two years on, that dream has largely become reality. But not in quite the way Morgan Stanley planned. For one thing, credit derivatives quickly emerged as a more ecient tool for constructing the product than the cash structure of the original Tracers and its imitators. Synthetic Tracers, the credit derivative version of Tracers, quickly eclipsed the original product and, along with JP Morgans high-yield product Hydi and European investment-grade index Jeci, set the template for later launches. The other big development has been the realisation that tradable index products need to be owned and sponsored by groups of dealers, not by a single bank. Most of the original batch of proprietary credit derivative indices have subsequently been folded into the multi-dealer indices known as CDX in North America and iTraxx everywhere else (see Credit derivative index timeline, page 6). By suppressing the primeval instinct of all investment banks to develop and trade proprietary structures, and by collaborating with their foes to create market-wide standards, credit derivative dealers have created a product that has surpassed all but their boldest ambitions. Todays credit derivative indices trade in volumes that were recently unimaginable for a credit derivative instrument

introduction 5

Credit derivative index timeline

November 2001 JP Morgan launches high-yield credit derivative index Hydi January 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 Paribas September 2003 Trac-x dealers launch Trac-x Asia September 2003 ABN Amro, Citigroup and Deutsche Bank launch iBoxx Diversied, 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-x Japan to form DJ iTraxx CJ

and with sucient liquidity to attract hosts of new users and a raft of spin-o products 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 continued development of this market (see chapter 6). A lot has changed since we developed Tracers, says Jared Epstein, head of credit derivatives trading at Morgan Stanley in New York. We used to pride ourselves on making a ve basis point bidoer on $10 million. Now the indices are quoted with a bidoer of less than half a basis point on $100 million. 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 as the established bond indices such as the Lehman Aggregate, but they allow people to observe how the market has moved on a daily and even hourly basis. The dealing costs for todays credit derivative indices are on a completely dierent scale to anything ever seen before in the credit market. An investment

6 credit index trading

manager that receives a new mandate to manage $200 million against a credit benchmark can put that money straight to work by selling protection on the index. The rm can then unwind the trade as it nds its choice of assets to invest in without losing more than a few thousand dollars through the bidoer (see chapter 2). Liquidity on this scale looks set to transform the credit markets. In three years time, credit will probably look more like the equity market than the xed income market, reckons Lisa Watkinson, global product manager for credit default swaps at Morgan Stanley in New York. Developments such as electronic trading, credit index futures and exchange-traded funds will make this asset class available to a much broader range of investors than those who buy cash bonds. There are already some signs of that vision becoming reality. Electronic trading of indices is now common between dealers and has reduced trading costs (see chapter 5), although it may be some time before traders outside the dealer community have access to executable prices on screen. Several derivative exchanges are working to develop futures contracts based on credit indices (see chapter 7). There has also been talk of basing ETFs on iTraxx and CDX, though since these instruments have to be approved by the Securities & Exchange Commission this could take some time. One ocial who has looked into ETFs reckons it could take the SEC 18 months to approve a product based on a credit derivative index.

Jared Epstein, Morgan Stanley: prided ourselves on making a ve basis point bidoffer

he emergence of tradable credit indices coincides with a much broader trend in the nancial markets. Since the launch of the rst crude equity indices such as the Dow Jones Industrial Average more than 100 years ago, investors have come to depend on an ever more sophisticated array of benchmarks 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 new investment strategy. Rather than simply hoping to pick a manager that outperforms a benchmark, investors are allocating part of their money to alternative investments promising high absolute returns and part of their money to instruments that track the indices. The same trend is beginning to emerge in credit. What you are seeing

introduction 7

Michael Pohly, Morgan Stanley: indexation could transform the credit markets

more and more of is the implementation of what had traditionally been equity-only strategies in the credit space, says Morgan Stanleys Epstein. For example, investors are often found using index-related products to get their beta and using alternative investments such as hedge funds to gain their alpha. In the equity market, this barbell approach to investment has led to a surge in the popularity of passive, index-tracking funds, as well as vehicles such as ETFs, that have lower management and dealing costs than traditional investment funds. Some believe the same thing could be about to happen in the credit world. In the same way that indexation has completely changed the equity market, I believe that credit derivative indices such as Dow Jones CDX and iTraxx could transform the credit markets, says Michael Pohly, global head of structured credit trading at Morgan Stanley in New York. For example, the creation of funds based on credit derivative indices could revolutionise the way money is managed. But for all their success, credit derivative indices have some serious limitations. And there are plenty of sceptics among those investment managers bankers would like to recruit to the cause. Perhaps the most fundamental aw of the indices is the process by which their constituents are chosen. The most important consideration for deciding whether a name should be included in iTraxx or CDX is whether or not it is liquid in the credit derivative market. This feature sets the tradable indices apart from every other index in the world, where composition is based on some measure of the value of the securities outstanding. The liquidity criteria were essential in allowing credit derivative dealers to oer and hedge the product, but it makes CDX and iTraxx a poor benchmark for long-term investment. Because they are based on liquidity, credit derivative indices do not track changes 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 most frequently. This bias towards the volatile is a good thing for anyone who wants to see changes in credit prices magnied, but it is debatable whether such a product can justiably be called an index. Furthermore, none of todays credit derivative indices enjoy the same credibility and transparency as the main equity indices, where committees spend months debating the ner points of free oats and market value weightings to be sure that they include the right constituents.

8 credit index trading

Main credit derivative indices, September 2004

Sector Region Number of names 125 125 50 30 100 30 30 30 14 25 Five-year midmarket price, bp (31 August 2004) 60.2 36.9 25.3 57.5 381.0 284.9 61.75 127.0 272.8 29.8

DJ CDX NA IG DJ iTraxx Europe DJ iTraxx CJ DJ iTraxx ex Japan DJ CDX NA HY DJ iTraxx Europe Crossover DJ iTraxx HiVol* DJ CDX NA HiVol* DJ CDX EM DJ iTraxx Australia

High grade High grade High grade High grade High yield High yield/ high grade High grade High grade Sovereign High grade

North America Europe Japan Asia ex Japan North America Europe Europe North America Emerging markets Australia

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

At the time of publication, there is no organisation charged with ensuring that the composition of North Americas CDX indices follows the rules laid down by its founders. Instead, names are essentially chosen by a handful of traders from the main market makers meeting every six months over latte and doughnuts.

n Europe and Asia the situation is slightly dierent, since the International Index Company (formerly known as iBoxx) is responsible for administering the indices. But even here, composition is decided based on rankings of names provided by the dealers to IIC, with each dealer ranking the names it In 2004 there has been has traded most heavily in the single-name market. Supporters argue that it would be hard to manipulate such a system. But a big increase in investors suspect that if a good proportion of the Street is axed on a particular 10-year trading name, the credit will nd its way into the index. And there have been more than a few instances in the past few years think of Enron or Parmalat where a companys voracious appetite for debt has put almost the entire dealing community long that name. The other big weakness of todays credit derivative indices though one that is a much less fundamental problem is that they are liquid only in a few select zones of the credit market. For example, most trades are still done to a single maturity: ve years. In 2004 there has been a big increase in 10-year trading as investors look up the yield curve to gain extra yield but it is still

introduction 9

Lisa Watkinson, Morgan Stanley: credit will become more broadly available

impossible to talk about a meaningful credit curve even for the most liquid indices such as CDX NA IG and iTraxx Europe. It is only in the ve-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. That is why the ve-year is so popular. Everyone wants to sell shorter-dated protection, but there is no bid. Credit index trading is still dominated by investment-grade risk in North America and Europe. However, the market is steadily broadening to include high-yield credit and names from other parts of the world. We will continue to see credit derivative indices expand, believes Morgan Stanleys Pohly. We have 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 o. In second-generation index products too, liquidity is concentrated in small pockets: mezzanine is by far the most liquid index tranche; option trades are concentrated in three- and six-month expiries.

lled. It is also possible that the indices can overcome the shortcomings of their basic design. Most indices exist initially as an exercise in price calculation designed 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 rms to trade the index directly. By contrast, credit derivative indices have put the cart before the horse. They have been designed to be traded from day one, and it is only now that they trade in large volumes that people are thinking about their other potential uses. Despite their initial success, transforming indices such as iTraxx and CDX into the credit markets equivalent of the S&P500 or Eurostoxx 50 is a big challenge. It will need many more asset managers, insurers, corporates and commercial banks to be persuaded of their benets. And it may require credit derivative dealers to give up some trading benets in favour of greater transparency and objectivity in portfolio selection.

ut it is hardly surprising that some areas of the market are more liquid than others, especially given the youth of the product. And there is every possibility that many of the gaps in credit index liquidity will soon be

10 credit index trading

Chapter 2 the investor viewpoint: beneting from efciency

o called real-money investors remain the largest untapped user base for credit derivative indices, and for credit derivatives generally. These are the investment managers who look after unleveraged pools of money for pension funds, life insurers, retail mutual funds and the like, by contrast to the leveraged funds invested by hedge funds and banks. Typically, activity among real-money investors remains limited to dipping a toe in the market. However, their involvement in CDX and iTraxx indices is growing, and is starting to include use of the indices for sophisticated asset allocation strategies. Regulation is one reason uptake has been slow. In contrast to the exibility aorded to hedge funds, real-money managers typically face more rigid guidelines, which often prohibit the use of derivatives altogether. Investment consultants play a key role in deciding how money should be put to work. A green light for credit derivatives from these consultants would bring many new investors into the market, say credit derivative bankers. A further complication is that where funds are pooled, managers need to get the go-ahead to trade from a large number of dierent accounts. Klaus Oster, head of credit research at German investment manager Deka, says the rm keeps an eye on credit derivative indices as an indicator, but is not currently using them to invest money. It is a mixture of having to clear various settlement and valuation issues with auditors, he says, as well as from a legal point of view the process of discussing credit derivative usage with our clients. Nonetheless, growing numbers of real-money managers are receiving mandates to trade credit derivatives, and this has resulted in a discernible increase in the ow of funds into synthetic indices. Promoters of credit derivative indices say that, in addition to basic hedging activity, tradable indices oer general asset managers a range of potential applications as part of their asset allocation strategies. The more sophisticated of these involve using credit derivatives indices to express sectoral views synthetically on a bond market benchmark. At a simpler level, credit derivative indices can be used to put funds to work while waiting for investment opportunities in the bond market.

the investor viewpoint 11

There is a broad trend for money managers to move away from an index-based approach

Increasingly dissatised with the returns from their traditional investment strategies, investors have increasingly begun to look at absolute return strategies in recent years, causing a sustained ow of money into hedge funds. However, for the vast majority of the worlds real money, investment continues to be judged in terms of performance relative to a benchmark. While credit derivative bankers talk hopefully of their tradable indices one day being adopted as popular performance benchmarks, to date all the money invested in relative value funds dedicated to credit is benchmarked against bond indices typically, the corporate component of broad bond market indices. Merrill Lynch, Lehman Brothers, Salomon Brothers and, in Europe, iBoxx are the main providers of these indices. There is a broad trend for money managers to move away from an indexbased approach, says Rizwan Hussain, investment-grade credit strategist at Morgan 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 those indices eciently.

hese broad market indices include sizeable baskets of government bonds, agency debt and structured nance securities in addition to corporate bonds. Clearly, credit derivative indices do not provide such a broad measure of diversied bond risk, although some analysis has shown that they are fairly closely correlated with the corporate bond indices oered as part of broad market benchmarks. But a key dierence between credit derivative and cash market indices is that bond indices are highly granular indicators of performance rather than investment and trading vehicles. Broad market indices include many thousands of securities, including, in the case of the corporate bond market, all securities larger than a certain dened size such as $250 million or $500 million. Their comprehensive nature makes them an invaluable resources for asset managers, who need to know how the bond market as a whole is performing. And this lack of granularity is one factor that is likely to limit the development of benchmarking against credit derivative indices in the foreseeable future. For real money investors, perhaps the most signicant benet of the likes of iTraxx and CDX is that they provide a means of allocating new funds quickly. Credit derivative indices can be a phenomenally useful tool for a credit manager, says Brian Arsenault, high-yield credit strategist at Morgan Stanley in New York. In the high-yield market, for example, cash bonds can be hard to come by. With an index like the CDX NA HY you can gain an instant long exposure to the market. Probably all asset managers agree that in theory credit derivative indices can provide a means of putting newly invested money to work quickly. But not all managers are happy with using the products in this way. Axa Investment Managers is one asset manager that uses credit derivative indices to allocate new money to credit. The index provides a quick way

12 credit index trading

of gaining exposure to the credit market for new money coming in to our funds, says Jean Pierre Leoni, head of credit products at Axa IM. You can make a quick allocation while waiting for opportunities in the bond market. Klaas Smits, head of credit at Dutch investment management rm Robeco, agrees with that statement. The index is very liquid and it is a good way of channelling new cash ow in and out of the market, he says. He adds that the liquidity that is available also makes the indices attractive for fund allocation when building up a CDO portfolio. It is a good way to ramp up the portfolio, he says. You can easily do 50 million to 100 million trades, so it is a smarter way to ramp up. There is the danger that people will know you are coming if you are out buying the cash assets. Robeco does not currently make use of credit derivative indices, but Smits says that the rm is looking at the instrument closely. We are on the brink of using them, he says. But Oster at Deka points out that parking money in this way brings risks. You can have a discussion over Jean Pierre Leoni, Axa IM: whether you should use the index or use single-name default swaps instead you can use the index to of the index, he says. Simply buying the index means you have exposure to make a quick allocation names 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 no need to take advantage of quick allocation through the index. We have large pooled corporate funds here which clients can buy and sell units of, so cash ow is easily invested or oset, she says. Credit derivative bankers point out that, besides quick asset allocation, the CDX and iTraxx indices can be used by money managers to express sectoral

the investor viewpoint 13

We are in a low volatility environment and if you want to express your positive and negative views, this is a very liquid way of doing so

views. They point out that adding a sectoral overlay to a cash benchmark synthetically is cheaper, because of the small bid-oer spreads on the derivative index, than constructing such a strategy in the cash market. In addition, sectoral trades can be more easily changed if they are done synthetically, rather than by buying or selling bonds. A synthetic sectoral allocation strategy involves buying the industry baskets of the credit derivative index in proportions that match the cash market benchmark. Then asset managers apply their overweight or underweight sector allocations synthetically by buying more or less of the baskets. However, a synthetic replica index will not track a cash credit benchmark perfectly. Partly this is because the names referenced by Traxx and CDX are equally weighted, rather than weighted according to market capitalisation, as is the case with cash bond benchmarks. As a result, some companies that are 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 indices are actively traded, and therefore tend to move around more in price than a cash index. Moreover, the theoretical basket of credit derivatives that make up the synthetic index does not trade perfectly in line with the underlying singlename default swaps. Typically the basket will tighten and widen more rapidly than the underlying constituents.

onetheless, 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 revealed a correlation of 0.89. The sectoral correlation between the two ranged from 0.70 for autos to 0.90 for technology, media and telecoms (see table). However, tracking error is undoubtedly one factor that makes asset managers cautious of the synthetic indices. For example, DeAMs McMellin says that basis risk is a reason why the investment management rm is not currently trading credit derivative indices. Our benchmarks are bond indices and we are not comfortable with the [cash versus synthetic] basis risk, she says. We do, however, have the systems, dealing capability and back oce processes in place to deal them if need be. If a client showed demand, or if we were given a 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 volatility environment 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

14 credit index trading

Correlation between iBoxx cash index sectors and their equivalent DJ iTraxx indices (reconstituted)
Reconstituted DJ iTraxx Master Corporate TMTs Autos and auto parts Industrials Consumers Energy Senior Subordinated
Source: BNP Paribas

iBoxx All Corps Non-nancial TMTs Auto Industrials Consumers Energy Senior Subordinated

Correlation 0.89 0.87 0.90 0.70 0.89 0.82 0.71 0.72 0.80

investment grade, you can do that. Therefore, if you are positive on high yield, because you are looking at an excess return of plus 100bp, the synthetic index is a very nice instrument. However, he adds that in the investment-grade market, spreads are currently too compressed to make synthetic overlays an attractive enough alternative to sectoral allocation via the bond market. The carry is so low, he says. DJ iTraxx has been trading around the 40bp level, and you have a 1bp to 2bp bid-oer 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 holding on to the cash bonds. Say you have a bearish view on telecoms and want to express that view, says Paola Lemedica, credit portfolio strategist at BNP Paribas. You can sell one or more of your telecom bond holdings. But with spreads 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. That way you can still make a more bearish view, but without having reinvestment risk. Leoni at Axa Investment Managers says that ease of execution makes credit derivatives indices attractive for taking sectoral views. You can put on trades quickly, and at a very low bid-oer spread, he says. It is an alternative to the more laborious process of buying or selling the bonds to express a view. Axa IM is in discussions with the French regulators about going a step further. We are working on providing a fund against an index that is based

the investor viewpoint 15

High-grade bond indices: key characteristics

Index Market value % non-nancials % nancials No of securities Minimum issue size (par value outstanding) Lehman US Lehman Euro Corporate Corporate $1.6trn 62.6 37.4 2,510 $250m 821bn 51.7 48.3 1,049 300m Merrill Lynch Merrill Lynch US Corporate EMU Corporate $1.9trn 64.1 35.7 3,665 $150m 1.1trn 48.8 51.2 1,352 100m iBoxx Corporate 653bn 57.6 42.4 679 500m

Source: Lehman Brothers, Merrill Lynch, iBoxx

only on credit derivatives, says Leoni. That gives you greater exibility for portfolio construction versus managing a portfolio against a broad [cash] market benchmark. For example, you might not want a benchmark with as large a weighting in telecoms and autos as the broad market benchmarks, or you might want to manage your portfolio against an index of European-only names in euros, rather than European and US names in euros. US names can make up 40% of euro broad market [cash bond] benchmarks.

16 credit index trading

Chapter 3 index tranches: from esoteric to ow

he growth of credit derivative indices is based on a straightforward trade-o. Dealers agree that they will all trade the same risk on the same standardised terms as each other. Margins fall as the product becomes more transparent and more widely traded. But liquidity rises to the point where increased volumes and new product development compensate for the income that dealers have lost on the core product. Nowhere is this process more in evidence than in credit index tranches. Once a high-margin spin-o of the main indices, these products have themselves quickly become part of the ow credit derivatives business. Credit index tranches have brought standardisation to what was previously one of the most customised and esoteric areas of the credit derivative market. These instruments are credit default swaps linked to a portfolio of names that are triggered only if losses within the portfolio rise above a certain threshold. Like a rst-, second- or third-to-default basket trade, tranches provide leveraged or deleveraged exposure to a credit portfolio. In addition to credit risk they also convey credit correlation risk: that is, the relatedness of the probability of defaults in that pool. Just as a credit price implies a probability that the particular name will default, so the price of a credit tranche implies the chance that the pattern of any 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 the factor that has changed is the implied correlation. Correlation is embedded in a whole host of credit products, but before the advent of tranche trading it was dicult to put a price on it. Standard index tranches are as signicant a development as the indices themselves, says Michael Pohly, global head of structured credit trading at Morgan Stanley in New York. They have for the rst time allowed people to observe how correlation trades. And they have provided the liquidity that allows people, including credit derivative dealers, to hedge credit correlation risk eciently for the rst time and mark their books to market based on real, observable prices. This benet of providing an observable market price for correlation is

index tranches 17

Tranches allow people to mark their books to market based on observable prices

particularly important in allowing dealers to recognise prots. Accounting standards increasingly require banks to use visible market-based parameters for marking their books to market. And the introduction of so-called observability requirements under GAAP and IAS accounting has been an important trigger for 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 collateralised debt obligations (CDOs). Like other credit index products they are credit default swaps traded with standard maturities and other terms. They provide exposure to a particular slice of credit risk across one of the standard credit derivative indices such as DJ CDX NA IG or DJ iTraxx Europe. And the attachment and detachment points of the tranches are also standardised. The tranches are slightly dierent for each of the main indices (reecting the dierent risk proles of the indices) but always include a rst-loss exposure, and various mezzanine and senior tranches (see table). The counterparty that buys 10 million of ve-year protection on a 3-6% tranche of DJ iTraxx Europe pays an annual premium (around 170 basis points in August 2003) and receives payments from the protection seller each time there is a default in iTraxx that leads to losses in the portfolio of more than 3%. If, over the ve years, there are 13 defaults on the 125 equal-size names in the contract and each recovers at 40% of par, the protection buyer will receive the full 10 million of protection. (But the protection buyer would not benet from a 14th default, since this would take losses above the 6% detachment point.) The standardised market in index tranches emerged in mid-2003, although some dealers had traded a few tranches based on the indices between themselves before that. The market was quick to take o, with tranches traded on the two European high-grade indices, Trac-x Europe and iBoxx Diversied, as well as on the North American products, iBoxx CDX and Trac-x North America. The market received a boost with the merger of the Trac-x and iBoxx

Standard credit index tranches: attachment and detachment points

iTraxx Europe First loss Junior mezzanine Senior mezzanine Senior Super senior 03% 36% 69% 912% 1222% CDX NA IG 03% 37% 710% 1015% 1530% iTraxx Japan 03% 36% 69% 912% 1222% CDX NA HY 010% 1015% 1525% 2535%

18 credit index trading

indices in June 2004. With the merger of the Trac-x and iBoxx indices, the volume of index tranches has increased dramatically, says Chris Boas, head of correlation trading at Morgan Stanley in New York. It is not uncommon for us to trade $1 billion of index tranches in a week. Bid-oer spreads have also narrowed sharply following the merger. On the highly liquid mezzanine tranches, for example, bid-oer spreads of between ve and 10 basis points are now common. As recently as early 2004, the bid-oer spread was usually more than 50bp, although the premium on 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 as liquidity has grown. The biggest group of new users are the fast money accounts hedge funds, prop desks and other outts that are free to trade in and out of positions frequently. A popular trading strategy has been for hedge funds to buy the risk that the Street, for technical reasons, is keen to ooad. Most credit derivative dealers have bought a lot of protection on senior portfolio tranches through bespoke trades, often called synthetic CDOs and CDOs-squared. This gives them a long exposure to correlation which, unlike the credit risk itself, has historically been dicult to hedge.

Chris Boas, Morgan Stanley: the volume of index tranches has increased dramatically

s a result, dealers have been keen to buy protection on junior and mezzanine tranches. This is a good trade for dealers, since it reduces the overall correlation of their book. And for hedge funds, which are typically looking for a leveraged investment rather than taking an outright view on correlation, it has been a protable strategy as credit spreads have declined. But the sale of junior tranche protection by hedge funds to dealers has not been the only trade in the market. When the index tranche market started, a lot of the ow was hedge funds selling 0-3% protection to dealers, says Boas. But since then, the market has become much broader. There are many dierent players using the market to hedge, speculate and take long-term views. That is reected in the increase in volumes and liquidity that we have seen this year especially. The European and North American markets are seeing rather dierent patterns of tranche trading in 2004. This reects something of a cultural divide. According to traders, whereas dealers European clients tend to think in terms of correlation, US rms are more focused on classic credit market concepts such as leverage and convexity (sensitivity of the investment to spread movements). At the same time, Europe has much stronger demand than the US for the kind of bespoke trades that create the Streets long correlation position.

index tranches 19

The result is that the New York dealer correlation desks tend 30 North America (DJ CDX.NA.IG) to see a greater variety Europe (DJ iTraxx*) of trades being done. In Europe we have all done 25 the same kind of bespoke trades, says a correlation trader in London. We are 20 all axed the same way and spend our time working out how to lay o some of 15 that exposure. In the US D J F M A M J J A it is much more of a two2003 2004 Source: Bear Stearns. Indicative mid-market data derived from proprietary models way market. * DJ Trac-x before 27 April 2004 As competition in the customised portfolio credit derivatives market has intensied, particularly Mezzanine implied correlation in Europe, the pricing 12 of bespoke tranches has North America (DJ CDX.NA.IG 3-7%) Europe (DJ iTraxx* 3-6%) become more aggressive. 10 That means dealers spend an increasing 8 amount of quantitative 6 re power tackling the issue of mapping, that 4 is, working out how 2 few trades they can put on through indices and 0 D J F M A M J J A remain hedged in their 2003 2004 structured credit books. Source: Bear Stearns. Indicative mid-market data derived from proprietary models * DJ Trac-x before 27 April 2004 In terms of bringing transparency to credit correlation pricing, the index tranche market is already bearing fruit. By far the most noticeable trend of the rst 12 months of trading history is the dramatic decline in implied correlations for the 3-6% and 3-7% tranches and, to a lesser extent, for the 03% tranches (see charts). Indeed, the level of implied correlation for the mezzanine tranche has fallen so low that some dealers have begun to question whether they are using the right mathematics to calculate implied correlation (see box). But as an observable market, implied correlation is still in its infancy, and it is dicult for traders to put todays numbers into historical context. The short

03% implied correlation

20 credit index trading

Relearning the language of correlation

Correlation is a reasonably straightforward concept, but the mathematics of turning tranche premiums into implied correlations is endishly 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, rather than 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.

history of index tranches gives us some sense of how correlation trades given relatively small moves in the underlying, says Sivan Mahadevan, head of credit derivatives strategy at Morgan Stanley in New York. It does not tell you what would happen to implied correlation in a more volatile market environment such as early 2002, although there were bespoke correlation products out there even then. If the high-grade index tranche market is still young, there are others that are even less well developed. But by the middle of 2004, there were growing signs of tranche trading beginning to take o 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 far behind those on the high-grade indices. Tranches of the high-yield index have been slow to take o because not all the names in the index are particularly liquid, says Boas. What might work better is to take the high-volatility subset of the investment-grade index and add double-B names from the high-yield index.

index tranches 21

History does not tell you what would happen to implied correlation in a volatile market

There have also been attempts to kick-start tranche trading in Asia. A number of dealers are now quoting prices on tranches of the DJ iTraxx exJapan index, the DJ iTraxx Australia product and on Japans DJ iTraxx CJ. But unlike in Europe and North America, there are few dealers with purely regional books of credit on which they need to hedge the correlation. So far, the purely Asian correlation business has typically consisted of small rst-todefault baskets, rather than tranches of wholly Japanese or Asian portfolios. Japanese credits trade so tight that there is not enough spread for customers to 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, Japanese customers have shown interest in domestic names by doing rst-to-default trades. Even so, Bear Stearns is one of a number of dealers that report having traded tranches of the various Asian indices.

ut whether Asian and high-yield index tranches take o or not, dealers are clearly determined to nd some new correlation-intensive products to provide a stream of prots now that margins in the high grade tranche business have evaporated. One idea has been to promote standard rst-to-default baskets based on the European and North American indices. Credit derivative dealers began making a market in these instruments in June and July 2004. Although a number of trades are said to have been completed, early indications are that this 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. This is not yet a product that is quoted in a standardised way but, if the track record of the tranche market is anything to go by, could one day be traded daily with tight margins in volumes of billions of dollars.

22 credit index trading

Chapter 4 index option trading: waiting for volatility

f the new generation of credit derivative products that liquid index trading was designed to make possible, the biggest success story has been index tranches. By contrast, the development of options on the indices has been less spectacular. Options are being actively traded on several of the main credit derivative indices, but the market remains much smaller than the tranche market. It is surprising to think that a 37% tranche of an index is more popular than a simple call option on spreads, says Sivan Mahadevan, head of credit derivatives strategy at Morgan Stanley in New York. But many investors are not used to thinking about optionality in credit, whereas tranches have been around for as long as the CDO market. That might be the reason correlation products have taken o 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 of rapid growth. And after years when credit spread options were much discussed but rarely traded, the launch of tradable credit indices has certainly been the trigger for the rst trading in credit spread options in any signicant volume. The credit options market has seen tremendous growth in the past 12 months, says Greg Tell, North American head of credit options and exotics at Citigroup in New York. One thing that has really kick-started the market is the expansion of index product trading. It has given people condence that there is a liquid market out there that allows them to delta-hedge options. And the development of index option trading has in turn helped a market in singlename 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. One trader reckons that in a typical week in mid-2004, some 50 to 60 trades went through across the Street, representing notionals of between $1 billion and $2 billion. Europe has lagged some way behind the New York market, but options are also regularly traded on the high-grade European iTraxx index. Take-up of the product has also been relatively strong in Asia, where reports of three- or six-month option trades on the DJ iTraxx Asia and DJ iTraxx CJ are becoming increasingly common. Asia has also seen some trading

index option trading 23

Europe has lagged some way behind the New York market, but options are also regularly traded

in single-name credit options, perhaps reecting the longstanding popularity of bond options in the region. While the rst 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 having traded options on the high-yield CDX NA HY index, although volumes are still overwhelmingly dominated by investment-grade risk. The market trades with European-style options (which can be exercised only on their expiry date) and premiums are quoted in basis points and paid upfront. 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 million are not unheard of. The greatest liquidity is in three- to six-month expiries struck close to the money and linked to a standard ve-year credit default swap. Options usually have expiries that coincide with the quarterly standard maturity dates. The contract which the buyer of the option has the right to enter normally has the same termination date as a ve-year credit default swap starting on the day the option is traded. So a typical six-month option traded on 1 October 2004 would give the right to buy or sell 4.75-year protection on 25 March 2005 (with the resulting trade terminating on the standard maturity date of 20 December 2009). Index options of up to nine months are known to trade, but beyond this expiry, the market hits a snag. Traders are unwilling to take a view on the value of 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 tenor that doesnt trade actively, for example 12 years, then you lose that liquidity. On the other hand, trading a long-dated option on a when-issued future index is dicult since there is no real economic way to price the eect of future rolls. The fair value of the index may increase or decrease depending on which names are included. Single-name CDS options dont face this issue, so we are more likely to see longer-dated options in that context rst. One factor that may have held back the development of the credit options market is the low level of actual (or realised) volatility Volatilitys tower of Babel in the credit market in 2003 and, especially, in 2004. As Right to buy protection Right to sell protection with any option market, = payer = receiver credit options are worth = put option on credit risk = call option on credit risk more to the buyer the more = call option on credit protection = put option on credit protection spreads jump around. As a result, there have

24 credit index trading

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

often been more people willing to sell options than buy them. The typical ows in the options market 50 have been from sellers of options looking for yield. For example, a counterparty that believes spreads 40 are unlikely to widen signicantly in the near future and wants to generate some income from the 30 option premium would sell the D J F M A M J 2003 2004 right to buy protection. However, Source: Bear Stearns. Indicative mid-market data derived from proprietary models some traders say there has been a shortage of natural option buyers, given the current market environment. Those ows can be seen in the price of credit options expressed in terms of implied volatility (see chart). The volatility implied by the price of options on the 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 dipped below 30%. That 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 killing in the early part of 2004. The two months after July, however, have seen a slight uptick in implied credit 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 ows and people are using the product in dierent ways, says Tell at Citigroup. You might have a hedge 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 a fundamental, long-term credit view. In the rst half of 2004, traders say the breadth of option trading strategies has increased considerably. For example, people now trade single-name options against index options and dierent expiries against each other. Some of the most active traders of credit default swap options are hedge funds and other so-called fast money accounts. These rms have emerged as some 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 baskets and index tranches (see chapter 3), spend a lot of their time hedging against credit spread movements. Often this can be done most eciently using options on indices and options on single names. A lot of the ow in the credit options market is from people hedging their
Payer Receiver

index option trading 25

Index options are set to become the basic workhorse of the credit volatility market

correlation books, says Chris Boas, head of correlation trading at Morgan Stanley in New York. Options on credit derivative indices can be an eective way of taking on or reducing credit convexity. Credit index options have become a core part of most dealers credit derivative business, with around a dozen rms making a market in the product in North America and a slightly smaller number in Europe. Some dealers trade the product alongside tranches from a general exotic credit derivatives desk. However, as the market grows, there is an increasing trend for rms to set up units dedicated to options. A number of dealers are beeng up their option trading businesses in preparation for a surge in volumes. Many traders believe that an uptick in actual credit market volatility would bring home to many potential users the benets of option trading. It is hard getting people to trade options when there is no volatility in the market, complains one banker. If this market takes o as many believe it can, trading straight options on the indices would not be a big money spinner for dealers. Unlike credit correlation, the mathematics of volatility are well understood, so there is little competitive advantage to be gained by developing a more sophisticated model for hedging index options. Instead, index options are set to become the basic workhorse of the credit volatility market, a low-margin, highly liquid instrument that can be one basic component of multi-leg option trading strategies and a hedge for more complex instruments (see box).

The next generation

Credit 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 oats in line with the prevailing spread of the underlying credit. For example a ve-year constant maturity default swap on Ford might pay a premium set as a proportion of the then ve-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 ve years, but at points between ve 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.

26 credit index trading

Chapter 5 trade execution: the pursuit of liquidity

he goal of providing better liquidity in the credit market has always been at the heart of the credit index project. By 2002, banks had spent several years touting the benets of credit derivatives to a wide group of potential users such as corporates, asset managers, hedge funds and insurance companies. And although the market experienced impressive growth in the early years of this decade, use of the product remained limited to a small section of the nancial services industry, chiey banks of one kind or another. One of the biggest obstacles to market access for many potential users was the credit derivative markets lack of liquidity. Consequently, one of the most notable features of the new generation of credit index products that sprang up in 2002 and 2003 was that their sponsors emphasised a commitment to making tight two-way markets. Of course, promising liquidity is dierent from delivering it, and it has taken a while for investors to be comfortable with the idea that liquidity will be there when they need it most. Certainly in the early days of the market, when credit derivative indices were provided by single sponsoring banks, it was harder to persuade investors that they could rely on good execution at all times. However, even after the market moved to a consortium-based approach to market making, it has taken time for investors to reach a point where they can assess liquidity condently. Until recently, for example, credit derivative indices had not been tested in the context of an investment-grade default. That 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. The Dow Jones Trac-x Europe index, which included Parmalat, traded at a bid-oer spread of three basis points or less throughout the debacle. That compares with the 2bp markets that were typically being made in the rival iBoxx Diversied 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 index trader at BNP Paribas, adding that BNP Paribas was making between 1bp

trade execution 27

Parmalat demonstrated to portfolio managers that they can buy protection in large size at any time

and 3bp markets in Dow Jones Trac-x Europe, in sizes up to 100 million throughout 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 rm Henderson Global Investors was one investor that was active in the indices around that time. We were using the Trac-x corporate and Trac-x Europe indices to give us a bulk hedge, says portfolio manager Daniel Beharall at Henderson. Parmalat had blown out as well as Adecco but liquidity was superb. It was a very satisfying hedge. We made money on the short side three months running. Henderson is not alone in delivering that verdict. Indeed, all the anecdotal evidence suggests that investors today are uniformly satised with the level of trading 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 Tracers index, which it introduced in the US market in April 2002. However, the real collapse in bid-oer spreads began around the end of 2003, as competition between the rival Trac-x and iBoxx indices became intense and as expectation grew that the two products would end up being merged into a single suite of super-liquid indices. From the 3bp or 4bp markets that were previously the norm on the main investment-grade indices, bid-oers were whittled down to 1bp or even zero basis points in some cases. A bid-oer spread of 0.5bp to 1bp has continued to be the norm on the main indices, following the creation of the combined Dow Jones CDX and Dow JP Morgan iTraxx/Trac-x Europe bidoffer Jones iTraxx brands (see chart). spread (bp) Dealers say that it is not unusual 5 for trades to get done in large size on a 0.5bp bid-oer. You 4 do see markets of 0.5bp on 100 million, says credit derivatives 3 trader Haider Ali at ABN Amro. It is phenomenal. 2 The high-volatility indices can also trade on very tight bid1 oers. For example, markets in the DJ CDX North America 0 S O N D J F M A M J J A S O ND J F M A M J J A HiVol, which has been trading 2002 2003 2004 in the 130bp region, have been Source: JP Morgan as tight as 0.5bp in mid-2004. Meanwhile, the DJ iTraxx

28 credit index trading

Crossover has been trading in JP Morgan iTraxx Europe the 300bp region on bid-oer spreads as tight as 4bp. bidoffer spread (bp) Liquidity in some of the 80 second-generation index 70 products has been almost as 60 impressive as in the main indices. Most notably, tranches of the 50 investment-grade indices have 40 seen a sharp compression in bid30 oer spreads since they began 20 trading in mid-2003. According 10 to JP Morgan, bid-oers on the 0 0-3% tranche of the European S O N D J F M high-grade index has come in 2003 from between 6% and 8% in Source: JP Morgan late 2003 to less than 1% by mid 2004. The biggest increase in liquidity coincides with the merger of the Trac-x and iBoxx products. As liquidity has increased, and as volumes have grown and dealing costs have declined, credit derivative indices have begun to follow other commodities away from a voice-intermediated, negotiated market towards a model where trading is done at the click of a mouse. There is not yet an exchange-traded credit index contract (see chapter 7). 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 Creditexs RealTime screen. And traders point out that customers of these banks should benet from the increased interdealer liquidity, as dealers compete to oer investors and hedgers good execution.

36% tranche

J 2004

Widest and tightest bidoffer spreads, July and August 2004

bp High DJ iTraxx Europe DJ iTraxx Credit Japan DJ iTraxx ex-Japan DJ iTraxx Hi Vol DJ iTraxx Xover 0.6 0.5 1.0 1.75 4.5 Low 1.0 0.75 2.0 2.25 7.25 % of premium High 1.4 2.0 1.7 2.5 1.5 Low 2.3 3.0 3.3 3.6 2.4

trade execution 29

Horses for courses: varieties of broker screen

E-trading system Trades are executed exclusively or primarily on screen without any interaction with the voice broker; brokerage rm 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.

Brokerage rms have oered a variety of dierent platforms for credit derivative trading. They range from pure screen-based systems to hybrid platforms incorporating both electronic and voice-brokered execution (see box). he relaunch of Creditexs electronic trading platform was the catalyst for the move into screen-based trading. Creditex was established in 1999 as an online trading platform for single-name credit default swaps, but switched to more of a conventional voice brokerage role after single-name e-trading failed to take o. But the rm was well positioned to launch an electronic platform for indices when the product became suciently liquid to allow electronic trading. Creditex set up an e-trading platform specically for European and US investment-grade indices, known as RealTime, early in Credit derivative 2004, and has subsequently added single-name trading as well. indices have begun The platform made an immediate impact. Liquidity shifted overnight, to follow other says one index trader. The switch was most pronounced in the North American commodities away from market where, at one stage, 99% of interdealer index trades were being executed a voice-intermediated, using the RealTime screen, according to traders. In Europe the ratio of screenbased trades to voice was put at 10 to one. negotiated market One obvious reason for the success of the system was that it reduced dealers brokerage costs. Execution on the Creditex screen costs $500 for a standard $25 million trade. That compares with the $2,500 per trade that dealers were paying for voice brokerage before the Creditex screen was launched. In response, other brokers quickly cut their voice broking fees to bring them close to the price Creditex was charging for online execution, which prompted volumes to swing back to voice brokers to a signicant extent, especially in North America.

30 credit index trading

Some traders suspect that the cheapest form of brokerage will always win out, regardless of the technology. But others see dierent forms of execution being used for dierent types of trade. Mazy Dar, Creditexs head of electronic trading platforms, puts the case for the screen as follows. There is a role for electronic trading and a role for voice, he says. The electronic system provides complete price and trade transparency as well as operational eciencies. The electronic system allows traders to easily place live, actionable prices, as well as receive automated end-of-day trade conrmations, 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 the screen-based trading systems, since the dealer that posts a price is committed to completing the trade at that level. Traders say that going through a voice broker, by contrast, can be a frustrating process, with trades sometimes falling through at the last minute. Reliability of pricing is a reason for using the screen, says a trader at a Michel Everaert, GFI: the large US bank in London. With Creditex you can look on the screen and you key phrase is price impact know you can trade those prices. That is dierent from being told by a broker that the trade is there and then have them say to you I call you o right as you are speaking to them. On the other hand you do not get the same market colour as you do going through a voice broker. Although Creditex has gained rst-mover advantage in the e-trading space, the development of platforms that combine voice and electronic trade execution are a new threat. GFI, which has traditionally been the biggest voice broker in credit derivatives, has taken the lead in this area, although other rms such as Prebon are also working on hybrid screens. GFI, however, has been the rst to launch a combined voice and actionable electronic screen, called CreditMatch. The system has been launched initially for single-name trading, but with the expectation that index trading will be added. We were advocating hybrid screen and voice execution ve years ago, says Michel Everaert, global head of sales and marketing at GFI. But the less liquid the market is the more sensitive price dissemination is. The key phrase is price impact. If you want to do a very large trade, say $100 million, on screen the price will have dropped and dropped again by the time you have completed the trade. On the other hand, if you want to do a standard size and there are 20

trade execution 31

iTraxx and CDX have emerged in a benign market environment

or 30 buyers and sellers and the market is pretty set on where the price is, there can be an advantage in advertising to as many people as possible by putting it on the screen. For rms that are customers of the big dealers, arguments over whether interdealer trading is done electronically or by voice brokerage may seem somewhat irrelevant. But the transparency and liquidity of the interdealer market has a direct bearing on the dealing costs that they pay.

or the many asset managers, hedge funds and other users of index products, the biggest issue is not todays bid-oer spread, but the likelihood 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. The only credit event that has aected a high-grade index is that of Parmalat. And that default was treated by the market as an idiosyncratic event: the Italian companys bankruptcy had no discernible impact on the spreads of other companies. The real test of the liquidity of the credit derivative indices will come when credit experiences its next bout of market-wide volatility. It will perhaps only be once the market has suered an event such as the failure of a big market maker, a series of related defaults or an external shock such as the terror attacks of September 2001, that credit traders can be sure that the index market has really achieved the deep long-term liquidity seen in markets such as equities and foreign exchange.

32 credit index trading

Chapter 6 infrastructure challenges: coping with the volumes

redit derivatives are still a relatively new market that lags well behind other, more established asset classes when it comes to operational eciency. Many in the market have long worried about its sometimes rudimentary architecture. The biggest problem we are facing right now is scalability, said a credit derivatives trading head in late 2002, expressing concern about the back oce failing to catch up with the increase in volumes the dealer was experiencing. But the infrastructure headache was about to become a lot more painful. The advent of credit index trading in 2003 has introduced a new dimension of complexity to the business. Even more important, the sheer volume of index and index-related trades threatens to clog up a system that has evolved on an ad hoc basis, and is still largely geared towards bespoke OTC contracts between large banks. That makes it essential for dealers and their customers to streamline and integrate their processes if the business is to continue to grow. Without much greater use of automation and common standards, bankers warn, the market will become clogged with the backlog of unprocessed trades and the resulting errors could do lasting damage to its credibility. Already, some estimate that index volumes represent at least one-third of all credit default swap trades. The speed of uptake has brought about a urry of infrastructure developments, and some of the challenges although by no means all are now beginning to be met. Industry association Isda noted in its latest operations benchmarking survey, released in June 2004, that data for less than a quarter of credit derivatives trades reached the back oce within one hour last year, and some deals had still not been received by the back oce by the following day. Isda advocates adoption of nancial products mark-up language (fpml) as a common data standard for institutions to exchange information electronically. And the setting of an fpml data standard for credit derivatives last year has paved the way for several initiatives designed to improve trade processing. The most signicant of these are conrm-matching services launched by the Depository Trust & Clearing Corporation (DTCC) and Swapswire. Both use

infrastructure challenges 33

Conrm afrm versus conrm auto-matching

Counterparty 1
Resolve exceptions Affirm trade details Indicate exceptions Submit trade Affirm trade details Indicate exceptions

Broker Counterparty 2



Counterparty 1

Resolve exceptions Receive matches Receive exceptions Submit trade

Counterparty 2

Submit trade S


Submit trade

Source: Isda

Receive matches Receive exceptions

fpml to receive trade details from counterparties and compare them (in the case of DTCC) or get them armed (in the case of Swapswire) see diagram. These services combine the processes of verifying, conrming and legally executing trades into a single event. If conrmed manually by fax and telephone it takes on average 21 days to conrm a transaction, according to Isda, whereas DTCC says that over half of all trades on its system match on initial submission, meaning, theoretically, that they can be conrmed within minutes. So far, DTCC has signed up about 40 users, including all the major dealers and a handful of end-users. It introduced a schema to enable it to match index trades in June, and banks will begin using the service shortly, once a standard index template is nalised. But some estimates suggest that under a quarter of all default swap trades are matched by DTCC or Swapswire. If only one party to a transaction subscribes to the service, it must still be conrmed manually. Not surprisingly, the bigger dealers are promoting automated conrm matching. Were encouraging all our clients to get on DTCC, says Jared Epstein, managing director and head of 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, far more than the current handful of hedge funds need to sign up to DTCC and Swapswire to create critical mass. Straight-through processing is a rarity among smaller institutions such as hedge funds and regional banks. According to Isdas benchmarking survey, no small rms used fpml at all last year, and only 8% planned to do so this year.

34 credit index trading

For the largest institutions, that gure was 80%. They have to balance the cost versus the size of the problem, says Michel Everaert, global head of sales and marketing at inter-dealer broker GFI in London. The alternative is taking an email or fax and inputting the data manually. This takes time and there is a risk of errors. But if you only type in two or three trades a day, the cost of automating the process may outweigh the benets. And those costs can be signicant. For a large bank to invest in the infrastructure necessary to automate all possible processes, expenditure can reach 1 million, not including personnel time. With DTCC the most eective way is to plug it into your server directly, but this can involve some relatively expensive investments and the timeline can be six weeks to two months, depending on your IT capacity, says Epstein. For smaller rms, however, DTCC is available as a web-screen user interface or le transfer process, 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 DTCC and Swapswire. We nd fpml applications relatively easy to integrate with, says Mel Gunewardena, managing director and global head of derivatives operations. Over the last few years, we have invested in building a real-time, back-to-front, fully integrated operating infrastructure across all derivative products. Once a trade is input, it automatically feeds all parts of risk, operations, collateral and client reporting.

ut many smaller rms are struggling to cope with the complexities of automating trade processing. If you have dierent systems involved, its very dicult to achieve straight-through processing, says a source at one 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 middleware to our existing systems, and will also enable us to use DTCC. With the growth of volumes and liquidity in credit indices, a new feature of the credit derivatives market has emerged. For the rst time since credit default swaps emerged some 10 years ago, trades are now being executed in signicant numbers electronically though, for the moment, only between big dealers. The shift towards electronic trading, through broker platforms such as Creditexs 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 the dealers back oce. Important steps that make e-trading possible are the selection of reference obligations ahead of trading, and the use of standardised terms such as standard maturity dates. The next stage for Creditex is to make application program interfaces (APIs) available to link directly to banks own systems. Looking ahead a couple of years, dealers would be able to input their trade parameters into their own trading model and that information would be posted directly from their system to Creditex, says Ben Lis, deputy

infrastructure challenges 35

Ben Lis, Creditex: dealers own trading model inputs will be posted directly to Creditex

chief technology ocer at Creditex. Until now, trade volumes have not made this worth doing, but at some point, it could become an impediment to the growth of the market. In addition to launching electronic trading platforms, some of the largest credit derivative inter-dealer brokers have switched to using fpml to exchange information with dealer clients. Creditex, for example, began oering deal verication in fpml and an fpml trade feed earlier this year. The latter provides real-time notications into a banks trade capture system for all default swap and index trades both e-traded and broker-assisted executed through Creditex. Garban currently sends fpml conrm details to Swapswire on behalf of four banks, and is currently the only broker that has signed up to the service. There is less scope for brokers to work with DTCC, since it matches details received directly from both counterparties. On Swapswire, by comparison, only one party which may be the broker submits trade details, and these are then armed by the counterparties. Prebon plans to join Swapswire later in 2004, and currently sends trade notications in fpml to one major bank client. But its preferred option is a trade notication service established earlier this year by a consortium of around 40 brokers, in which the broker inputs trade details and sends them to both dealers via the internet. Straight-through processing is not a competitive advantage, says Tim Dennis, head of business development in the technology group at inter-dealer broker Prebon. The broking industry should use it as a customer service, so the consortium approach is the right one. The client has just one pipe to receive notications, rather than an individual pipe for each broker. 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.

he hybrid screen-and-voice PrebonEdge trading platform is a webbased system. The 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 rewalls, says Dennis. The platform was developed by software vendor Trayport and provides an API enabling trades to be sent directly to banks back-oce systems. Trayports trading platform is not just available to brokers. Sales manager Richard Klin says banks could also deploy the system which introduced credit default swaps and indices in July to their clients. Klin is adamant that e-trading is the way forward for bank-to-customer trading, even if deals must actually be executed by telephone or instant message. Trades can be automatically passed to the mid- or back-oce system, so the trader doesnt need to input data. This gives traders more time to do deals, he says. There is little sign yet, though, that banks are investing in e-trading solutions for their customers. Most post Bloomberg pages and runs on their

36 credit index trading

client website, and supplement these with price updates by email, while some oer clients real-time information on all their positions, transaction summaries, payment and settlement details and even analytics. But trades are still actually executed over the phone. Weve talked about putting up prices that are executable, says Mike Srba, head of European corporate credit trading at Royal Bank of Scotland. Some banks have tried it, but the feedback hasnt been that positive. Market participants are condent, however, that indices will, in future, be traded on exchanges or used as the basis for futures contracts (see chapter 7). Within the next few years this will happen, and we are in the process of guring out how it will impact on our business, says Morgan Stanleys Epstein. It will denitely change the way we trade, how we book trades, and how we interact with clients. Some software providers are also preparing for this eventuality. John Mooren is business solutions director at Front Arena, a straight-through processing system owned by SunGard. He plans to be ready if exchanges such as Eurex and the Chicago Board of Trade (CBOT) begin trading futures based on iTraxx. Our customers wouldnt need to use the application supplied by Eurex or CBOT, says Mooren. They would be able to send a quote or order automatically to market and look at the market in Front Arena, then hit a price if they wanted to trade. Front can already interface with Creditexs e-platform and send data to DTCC and Swapswire. Index trading provides a good sales opportunity for software suppliers such as SunGard, as it is bringing credit derivatives to smaller players that might not have considered entering this market before. Smaller institutions dont want a silo-based tool for credit derivatives, says Mooren. They want one platform to do all their trading, sales and risk management for all the products they trade. And they are willing to sacrice some functionality for a system that is broader in terms of asset classes. Twenty-ve clients currently use Front Arena for credit index trades. One particular burden that credit derivative indices impose on all systems is the half-yearly roll, where the constituents of the index change. You only need to do this every six months, but every manual

John Mooren, Front Arena: smaller institutions dont want a silo-based tool for credit derivatives

infrastructure challenges 37

Getting the names right

One initiative designed to oil the creaking gears of the credit derivatives market and one that is integral to automated trade processing is Red, a database of reference entities and reference obligations run by Mark-it Partners. This currently consists of 1,200 entities and 1,700 obligations, each of which is assigned a nine-digit code or Clip. Before Red was created, trades were frequently disputed because reference entity and obligation details failed to match sometimes for reasons as trivial as letters being capitalised or full stops placed after initials. Red currently has about 40 subscribers, of which half are investment banks and the remainder an even split between second-tier banks and hedge funds. Most rms receive the information as a daily XML download into their systems. The vast majority of the Street is now using Red, and of the rms signed up to DTCC, 80% use Red, says Penny Davenport, a director at Mark-it Partners. Not every institution supports Red, however. Some say they have their own databases of reference obligations and dont want to pay for another; others complain that the service Mark-it Partners offers used to be provided free by banks. And although Red is operated on behalf of the banks and is not a prot-making vehicle, some believe it is too expensive. Either its overpriced or theyve undersized the market, says Jeremy Harris, chief operating ofcer Dow Jones CDX NA IG.2 Effective Date: 23rd March 2004 at data provider Credit Market Version 1. Annex Date: 6th July 2004 www.mark-it.com Analysis. I suspect marginal Reference Entity Sub-Index CLIP Reference Obligation CUSIP Monoline 1 ACE LIMITED Financials 0A4848AB1 ACE 6% 4/1/07 004408AB6 customers wouldnt touch it at 2 Aetna Inc. Financials 0A8985AA9 AET 7.875% 03/01/11 00817YAB4 3 Albertson's, Inc. Consumer Products and Retail 0B4414AA2 ABS 7.5% 02/15/11 013104AJ3 4 Alcan Inc. Basic Industrials 014A87AB4 AL 4.875% 9/15/12 013716AR6 the prices theyre quoting. 5 Alcoa Inc. Basic Industrials 014B98AA1 AA 6.5% 06/01/11 013817AD3 6 The Allstate Corporation Financials 0C2002AA5 ALL 7.2% 12/1/09 020002AK7 And Tim Dennis, head of 7 ALLTEL Corporation TMT 0C203CAA0 AT 7% 7/1/12 020039DB6 8 Altria Group, Inc. Consumer Products and Retail 0C4291AA2 MO 7.75% 01/15/27 718154CF2 9 AMERICAN ELECTRIC POWER COMPANY, INC. Energy 027A8AAB2 AEP 5.375% 03/15/10 025537AD3 business development in the 10 American Express Company Financials 027D97AA4 AXP 5.5% 09/12/06 025816AN9 11 American International Group, Inc. Financials 028EFBAB3 AIG 0% 11/09/31 026874AP2 technology group at inter-dealer 12 Amgen Inc. Consumer Products and Retail 0D4278AB5 AMGN 0% 03/01/32 031162AE0 13 Anadarko Petroleum Corporation Energy 0A3576AA1 APC 6.125% 03/15/12 032511AT4 14 Arrow Electronics, Inc. TMT 0E69A8AA4 ARW 6.875% 06/01/18 042735AL4 broker Prebon, says: Its a 15 AT&T Corp. TMT 001AECAB1 T 7.3% 11/15/11 001957BC2 16 Baxter International Inc. Consumer Products and Retail 0H8994AA6 BAX 6.625% 02/15/28 071813AM1 very expensive solution. At the 17 BellSouth Corporation TMT 07GHE6AA0 BLS 6% 10/15/11 079860AB8 18 Boeing Capital Corporation Basic Industrials 09G715AB2 BA 6.1% 3/1/11 097014AD6 19 Bombardier Capital Inc. Basic Industrials 09GEBUAB1 BOMB 6.125% 6/29/06 09774MAG1 moment, I dont think there is any 20 Bristol-Myers Squibb Company Consumer Products and Retail 1C1134AA6 BMY 5.75% 10/1/11 110122AG3 21 Burlington Northern Santa Fe Corporation Basic Industrials 1D39H2AA4 BNI 6.75% 7/15/11 12189TAT1 necessity for us to have it. Mark-it Partners was unable to reveal costs to Credit ux , but Davenport 22 Campbell Soup Company Consumer Products and Retail 1E786BAC8 CPB 4.875% 10/01/13 134429AS8 23 Capital One Bank Financials 1F444NAB5 COF 6.7% 05/15/08 14040EEE8 24 CARNIVAL CORPORATION Consumer Products and Retail 1F79BDAC3 CCL 2% 04/15/21 143658AN2 says the rm welcomes the opportunity to discuss the matter with potential users. 25 Caterpillar Inc. Basic Industrials 15DA35AA5 CAT 6.55% 05/01/11 149123BH3 26 Cendant Corporation Consumer Products and Retail 1G6444AC1 CD 7.375% 01/15/13 151313AP8 27 Centex Corporation Basic Industrials 1G7543AC9 CTX 7.875% 2/1/11 152312AG9 Mark-it Partners latest application for Red is designed specically to improve the efciency of 28 CenturyTel, Inc. TMT 16BD70AA6 CTL 8.375% 10/15/10 156700AA4 29 The Chubb Corporation Financials 1I8355AB5 CB 6% 11/15/11 171232AF8 credit index trading. Trading credit indices has presented a major operational challenge because of 30 CIGNA Corporation Financials 137A59AA7 CI 7.875% 5/15/27 125509AZ2 31 Cingular Wireless LLC TMT 1I96CZAB3 CNG 6.5% 12/15/11 17248RAF3 32 CIT Group Inc. Financials 137AD9AF7 every CIT 7.75% 04/02/12 125581AB4 the need for both counterparties to conrm detail down to the coupons and maturity dates of 33 Citizens Communications Company TMT 18B98EAA0 CZN 9.25% 05/15/11 17453BAB7 34 Clear Channel Communications, Inc. TMT 19C952AA6 CCU 7.65% 09/15/10 184502AK8 specic obligations for every single name in the index, to avoid disputes. 35 Comcast Cable Communications, LLC TMT 2C02BLAA7 CMCSA 6.75% 01/30/11 20029PAL3 36 Computer Sciences Corporation TMT 2C5899AA9 CSC 7.375% 06/15/11 205363AE4 37 ConAgra Foods, Inc. Consumer Productsas and Retail 225DGFAA8 CAG 6.75% 9/15/11 default 205887BA9 swaps. However, where a single-name Index trades are documented conventional credit 228A7HAA7 38 CONOCOPHILLIPS Energy COP 4.75% 10/15/12 20825CAE4 39 Constellation Energy Group, Inc. Energy CEG 7% 4/1/12 210371AH3 credit the 2D13A8AB0 reference entity reference obligation in the conrm, an 40 Countrywidedefault Home Loans, Inc. swap simply names Financials 2E45A1AA7 CFC 5.625% 07/15/09 and 22237LMY5 41 Cox Communications, Inc. TMT 2E6448AA0 COX 7.75% 11/01/10 224044AY3 42 CSX Corporation Basic Industrials 138A48AA9 CSX 6.75% 03/15/11 126408AP8 index trade has a separate annex detailing all the different names in the portfolio. 43 CVS Corporation Consumer Products and Retail 138CB5AA3 CVS 5.625% 3/15/06 126650AD2 44 Deere & Company Basic Industrials 2G85AIAB9 DE 6.95% 04/25/14 244199BB0 Differences between two banks version of the annex inevitably caused backlogs in deal processing. 45 Delphi Corporation Basic Industrials 26AF99AB8 DPH 6.5% 05/01/09 247126AB1 46 Devon Energy Corporation Energy 2H68GVAB8 DVN 6.875% 9/30/11 25179SAC4 47 Dominion Resources, Inc. Energy 27CBAFAB7 D 6.25% 06/30/12 25746UAJ8 In July 2004, however, Mark-it Partners introduced standard annexes for each of the tradable credit 48 The Dow Chemical Company Basic Industrials 2I6597AA5 DOW 6% 10/01/12 260543BR3 49 Duke Energy Corporation Energy 28A7CIAB8 DUK 6.25% 1/15/12 264399DW3 50 E. I. du Pont de Nemours and Company Basic Industrials 2I9887AA7 DD 6.875% 10/15/09 263534BJ7 derivative indices. These are signed upfront by dealers, eliminating the need for counterparties to 51 Eastman Chemical Company Basic Industrials 29EB75AC5 EMN 7% 4/15/12 277432AE0 52 Eastman Kodak Company TMT 29EBA7AB9 EK 3.625% 05/15/08 27746QAE4 exchange individual annexes each time they trade (see gure). 53 Electronic Data Systems Corporation TMT 2ADBC7AA7 EDS 7.125% 10/15/09 285659AE8
54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 EOP Operating Limited Partnership Federal Home Loan Mortgage Corporation Federal National Mortgage Association Federated Department Stores, Inc. FirstEnergy Corp. FORD MOTOR CREDIT COMPANY General Electric Capital Corporation General Mills, Inc. General Motors Acceptance Corporation Goodrich Corporation HALLIBURTON COMPANY Harrah's Operating Company, Inc. The Hartford Financial Services Group, Inc. Hewlett-Packard Company Honeywell International Inc. Ingersoll-Rand Company Financials Financials Financials Consumer Products and Retail Energy Basic Industrials Financials Consumer Products and Retail Basic Industrials Basic Industrials Energy Consumer Products and Retail Financials TMT Basic Industrials Basic Industrials 28EFDCAA0 343A80AA3 3E48EVAC6 3E549IAA3 36AGC5AA1 3H98CGAA3 39FF84AA0 3A7367AA8 3A7467AC2 3BA5BGAB9 4E6837AC8 4F4989AB8 457B66AA2 46AA59AB1 47BD67AA7 49BEECAA1 EOP 7% 7/15/11 FHLMC 5.5% 09/15/11 FNMA 4.375% 09/15/12 FD 6.625% 04/01/11 FE 6.45% 11/15/11 F 7.25% 10/25/11 GE 5.875% 02/15/12 GIS 6% 02/15/12 GM 6.875% 08/28/12 GR 7.625% 12/15/12 HAL 5.5% 10/15/10 HET 7.5% 1/15/09 HIG 7.9% 6/15/10 HPQ 6.5% 7/1/12 HON 7.5% 03/01/10 IR 9% 08/15/21 268766BU5 3134A4HF4 31359MPF4 31410HAS0 337932AB3 345397TY9 36962GXS8 370334AS3 370425SE1 382388AP1 406216AR2 413627AE0 416515AE4 428236AG8 438516AK2 456866AG7

38 credit index trading

intervention leaves room for error, says Fronts Mooren. If the information on changes to the index comes in electronic format, that information can be stored in the database and you can let it update automatically. In many institutions, the straight-through processing chain breaks down for credit index trades when they enter a banks accounts system. The general ledger is often a very old system, says Mooren. Credit default swaps are new products, which can create a problem, so banks often need to use manual workarounds. Calypso a vendor that has traditionally geared itself towards larger players also sees credit indices as a way to attract smaller rms. It oers a more exible, Java-based system with a congurable workow, which allows users to set up their own rules for straight-through processing and, in some areas, enables them to interface with their proprietary analytics. The company is currently automating several areas that still require manual input, such as selecting index constituents and upfront fees, and integrating with service providers. It already links to Mark-its Red database and is working on connections to Creditex and DTCC. For anything that is market standard, well try to take the initiative and build it in, says Rupa Bhagwat, Calypsos marketing manager. For something more proprietary, its up to the individual user, but we can provide some level of consultation.

You need to be able to handle hundreds of names and multiple curves for each name. Its difcult to do that in a spreadsheet

or the many smaller rms such as investment managers and regional banks that are moving into credit index trading, full-blown vendor packages or systems developed in-house are an expensive option. However, according to Mike Liberman, chief technology ocer and head of quantitative strategies at hedge fund manager Blue Mountain Credit Alternatives, getting by on spreadsheets and ad-hoc systems is simply not feasible. To be a player in the alternative credit markets, you cant just trade indices; you would do singlename credit default swaps too, and more sophisticated instruments like CDOs and options, he says. You need to handle hundreds of names and multiple curves for each name. You also need a lot of information, from reference data to risk, middle-oce and operational reports. Its dicult to handle all this in a spreadsheet. Not surprisingly, many hedge funds choose to outsource their entire back-oce and reporting processes to a specialist administrator such as GlobeOp. We upload trades to our administrator on an intra-day basis and the reconciliation process takes place from their database to ours every day, says Liberman. They store all our positions and deal with clearing, making and receiving payments and reconciling accounts. The key is to get their system to dovetail with ours. The only disadvantage is that an administrator can never match all the needs of a rm like Blue Mountain. Were constantly innovating and trading new products, so its sometimes dicult for them to handle everything we throw at them, says Liberman.

infrastructure challenges 39

Our system gives warnings and triggers to send notications subsequent to credit events, but there are some manual aspects, given the uniqueness of each event

As the credit index market grows and evolves, the industry will face an ever greater need to automate and streamline dierent aspects of the business. The next big area of focus for the market might well be credit-event management. At present the various notices sent from one counterparty to another following a default are typically handled manually, although changes may be afoot as support for credit event notices was recently added to fpml. This might be an area where full automation is dicult to achieve, since credit events are often disputed. But traders point out that even an indisputable credit event such as Parmalats in December 2003 can impose a huge administrative burden because of the sheer number of notices that must be sent and received on dierent trades. Our system gives warnings and triggers to send notications subsequent to credit events, but there are some manual aspects, given the uniqueness of each event, says Goldman Sachs Gunewardena. Meanwhile, Morgan Stanley is currently developing a workow model to process the necessary documentation to increase automation in credit event management. Automating post-trade processes such as payment reconciliation, settlement and netting is also on the agenda. DTCC is already involved in this space, expanding its conrmation service last February to automate payment reconciliation in ve currencies between counterparties on a quarterly basis. The role of fpml is likely to expand in future to cover payment and settlement. Brian Lynn, former co-chair of the fpml standards committee, says: The area of settlement notication and reconciliation is something that fpml sees as an important area to work on in the near future. The current reconciliation process is almost entirely manual, with counterparties contacting each other by telephone ahead of payment or settlement dates to agree payment amounts, conrm dates and check account details.

40 credit index trading

Chapter 7 the futures of credit indices: deeper, broader, cheaper

to answer. Starting with rst-to-default baskets and investor-led synthetic CDOs, credit derivative bankers have spent years trying to persuade customers that their products can be a good macro hedge or proxy investment for the broader credit market. But earlier multi-name credit derivatives suered, to varying degrees, from two disadvantages: they were illiquid and they were not representative of the market as a whole. Tradable credit derivative indices come much closer than their predecessors to solving the problem. But liquidity is still dependent on the willingness of a small group of credit derivative dealers to make a market in the product (see chapter 5). And the various CDX and iTraxx indices still suer from one signicant drawback: they do not pretend to be completely representative of the credit market, but simply of the parts of the credit market that are most liquid in credit default swap form. For many, the ultimate goal is a product that exists independently of the credit derivative dealer community. It is one where portfolio selection is suciently rules-based to enable people to take a view on the direction of the index well into the future. It is a natural place for buyers and sellers of risk to meet, providing certainty of liquidity over the long term. For many, an exchange-traded credit index contract such as a credit spread future seems to full most of those requirements. Trading on exchange would, it is argued, eliminate issues of counterparty risk and make the product accessible to a much wider community of traders. That, in turn, would cement the liquidity of the product, boost the liquidity of the overall credit market, and allow credit derivative indices such as iTraxx and CDX to become more representative of the broad market. One benet of a futures contract would be that it would make settlement of trades much more straightforward, says Lisa Watkinson, global product manager for credit default swaps at Morgan Stanley in New York. Another benet is that it would greatly broaden the investor base. It removes the

hat do you do if you want to go long or short the broad credit market quickly and eciently? That, in a nutshell, is the question that credit derivative indices such as CDX and iTraxx have evolved

the futures of credit indices 41

Lars Hamich, STOXX: looking for futures exchange partners

barriers to entry to the credit market for investors such as mutual funds. Some traders worry about the decline in margins that an exchange-traded credit index product might bring for dealers. Many express the view that since the indices are already highly liquid there is little to gain by putting contracts on an exchange. But some heads of trading at major dealers welcome the development. Most credit derivative dealers would like to have the index traded on an exchange or as a futures contract, says Jared Epstein, head of credit derivatives trading at Morgan Stanley in New York. This would allow everyone to tap into the same pool of liquidity. In addition, listing the index on an exchange would help further grow the market since it would attract participants who generally shy away from buying over-the-counter products. Various initiatives are currently taking place to develop a futures contract, each using credit indices as the underlying asset but each taking a slightly dierent approach. Derivatives exchanges, for their part, are keen to nd a new risk for people to trade on-exchange and want to tap into the fastest-growing derivative market of recent years. And there is no doubt that the volumes traded on credit derivative indices could form the basis of a successful exchange-traded contract. If you transfer 10% to 15% of those derivative index volumes to an exchange you have a very successful product, says Lars Hamich, managing director at index provider STOXX, which is looking at the branding potential of credit futures via its Dow Jones Indexes business. To date, several exchanges have expressed an interest in developing a listed index credit derivative, but none of the parties involved has yet gone public with details of its project. As long ago as late 2003, ABN Amro, Deutsche Bank and Citigroup announced that they were developing a contract based on the iBoxx index, though the merger between iBoxx and Dow Jones Trac-x is thought to have derailed the timing of this project. Nonetheless, collaborative work is continuing between banks and exchanges, with Eurex and Euronext in Europe, Chicago Board of Trade in North America, and Tokyo International Financial Futures Exchange and the Singapore Stock Exchange all having conrmed that they are in the running. So how might an index credit future work, and what problems are created by basing a contract on an underlying basket of default swaps? The contract would work quite dierently from a conventional over-thecounter credit default swap: The contract would be electronically traded with an exchange acting as the central counterparty, rather than bilaterally between two counterparties. The credit future would be based on the performance of an underlying index, for example, the DJ iTraxx Europe or DJ CDX North America,

42 credit index trading

Principles of the central counterparty (Eurex)

Market participants
Member A Member B

Trading platform






Central counterparty

Eurex Clearing

Settlement instructions

International Central Securities Depositories



SIS SegaInterSettle
Source: Eurex

with traders agreeing to buy or sell at a designated future date the value of the index xed today. For example, the contract might be bought and sold based on a quarterly delivery date, with the last trading day occurring two business days prior to the delivery day. As with other futures markets, contracts would typically be fullled by osetting: that is, the obligation to deliver would be fullled by taking a long position in a contract with the same expiry month. Margining requirements would apply, with positions marked-to-market daily and investors required to maintain a minimum level of margin, calculated as a proportion of the current value of the position. The initial margin would be a small percentage of the futures contract, giving leverage. There are two big stumbling blocks in creating a watertight structure for credit index futures: documentation and settlement. Exchanges that have looked at credit futures are known to be sceptical about the suitability of current

the futures of credit indices 43

Lee McGinty, JP Morgan: favours a cash-settled index future

credit derivative documentation for an exchange-traded futures contract. Credit default swap conrms are bilateral contracts, says one exchange ocial who declines to be identied. There are far too many elements that are subject to dierent interpretation to work as an exchange-traded contract. A futures contract needs to be short, simple and unambiguous. But as anyone who has been involved in drawing up credit derivative documentation knows, default is, by its nature, a complex and ambiguous risk. And that is hard to capture in legal language. Yet for a futures contract, the default of a name in the index would have to be triggered simultaneously on all contracts. With virtually every credit event we have had disagreement over the exact timing of the event, says one credit derivatives trading head. But if it is an exchange traded contract you cannot trigger just some contracts. That is a weakness of the credit future. Settlement is another thorny problem. Exchange traded futures can have physical settlement, with the trader able to take delivery of the actual goods at expiry of the contract. Alternatively, they can be entirely cash-settled, with the market value of the underlying used to settle the contract. In both approaches, a daily end-of-day price is calculated and that price is used to calculate margining requirements. For a credit contract, there are problems with both approaches to settlement. With physical settlement, the key question is what is delivered, since the underlying assets (index credit default swaps) are themselves derivatives. One mooted solution is for dealers to pool their resources to create a highly creditworthy entity that could issue notes linked to the reference entities in the index. Some banks, among them JP Morgan, favour a cash-settled index futures contract. They say that while physical delivery is the ideal, it would inevitably introduce some element of counterparty risk. STOXXs Hamich is among those who think that cash settlement might be the better option. The simplest model may prove to be the most attractive, he says. However, as an index provider we leave it to the exchange to gure out the best solution for the market, whether this is cash settlement or physical delivery. Someone has to issue this note, be it a consortium of market makers or an SPV. Either way there is some sort of risk prole to the note that has to be put into the model.

44 credit index trading

Lee McGinty, head of credit derivatives strategy at JP Morgan, points out that any credit-linked note could become illiquid. With the settlement note it is being proposed that a collateral manager or agent would be built up, which you would use to tap and redeem the notes, he says. However, the note might be limited by supply and demand factors, and there could be the risk that you would not be able to redeem at all times. There is the question of how quickly you will be able to redeem if everyone wants to sell their positions. But proponents of a credit-linked note approach argue that cash settlement is too open to price manipulation without some kind of physical settlement fall-back. Where futures are based on assets that are themselves traded on exchange such as equities it is straightforward for the index to calculate the price of the underlying index. But with credit derivatives, the exchanges would be dependent on others such as the dealers themselves to provide the pricing inputs. If the futures contract is cash settled the question is what mechanism do you use? asks one head of credit derivatives trading in London. You would need to be asking for dealers two-ways to come up with an average, but that can be a pretty fraught process and can depend on who is inuential that day. JP Morgans McGinty concedes that cash settlement of credit derivatives is a sensitive area that would require careful handling. In an ideal world you would go for physical settlement because it makes price manipulation harder, he says. However, the disadvantages associated with physical settlement outweigh the advantages. Cash settlement on balance is preferable, and it is possible to structure the settlement in such a way as to remove any perception of mistrust. He proposes the use of an auction system to x the settlement price, involving dealers placing orders on the prices they are showing. On the day of settlement, dealers would place not just their view on the spread but the point at which they would be prepared to buy or sell, he says. Such a system could perhaps be extended to taking orders from clients to put into the auction, with the clearing agency settling those contracts that cross each other.

In an ideal world you would go for physical settlement because it makes price manipulation harder

espite the many challenges facing the introduction of an index credit future, the momentum behind its development is now considerable. Bankers conrm that some exchanges have already run price tests for the daily marking to market of a credit future. Meanwhile, Tokyo derivatives exchange Tie recently began distributing a benchmark rate for credit default swap transactions, and says it plans to use the reference rates as settlement prices for new credit derivative products, to be listed on the exchange in scal year 2005. The exchanges concede that creating a credit index future is no straightforward task. But they point out that exchanges have had success in listing contracts based on assets that are not themselves exchange-traded. For example, Bund futures trade on exchanges such as CBOT without

the futures of credit indices 45

Several exchanges have misgivings about the opaque process used for selecting names in CDX and iTraxx

the underlying being traded on the exchange. In the case of the CBOT Bund future, prices are derived from underlying cash market prices supplied by Financial Times Interactive Data, which in turn derives its prices from the electronic government bond trading system, EuroMTS. Many banks favour the dealer-owned price service Mark-it Partners as an obvious choice for providing settlement prices for a credit future. The rm, which provides daily xings on credit derivative indices and single-name default swaps based on dealers marks, was launched in 2001 with the stated aim of creating a global benchmark for credit pricing. But this system of collecting price data is not without its critics, who argue that dealers marks often do not reect the price at which people are actually willing to trade especially for illiquid credits.

erhaps the exchanges biggest fear is that liquidity in the underlying credit derivative index could dry up as quickly as it has arrived. Several that have looked at the potential of this product are known to have misgivings about the opaque process used for selecting names in CDX and iTraxx. The system of dealer committees, liquidity rankings and the like stands in marked contrast to the objective process used to decide composition of broadly traded equity indices, for example, which are based on measurable factors such as market capitalisation. This raises the possibility that exchanges might try to launch futures contracts based not on iTraxx or CDX but on some other credit index. It might well be their preferred solution provided they can persuade institutions to trade such a contract. For now, the likelihood is that todays credit derivative indices will morph into something more like an S&P 500 or EuroStoxx 50 robust, transparent constructs that can support exchange trading, long-dated options, futures, ETFs and the like. But it is entirely possible if dealers fail to ensure their long-term credibility that credit derivative indices could miss out on the chance to become the deep and liquid exchange-traded credit instruments of the future. If that happens, the likes of Synthetic Tracers, Trac-x, iBoxx, CDX and iTraxx could end up as little more than a footnote in the history of credit index trading.

46 credit index trading

attachment point the minimum level of losses in a portfolio to which a tranche is exposed asset correlation the degree to which asset values (and therefore, according to the Merton model, default probabilities) move in tandem. Equity prices are widely taken as a proxy for asset correlation call option an option contract giving the owner the right, but not the obligation, to buy a specied amount of an underlying security at a specied price within a specied time. For credit default swap options, a call option can be a call on risk (receiver) or on protection (payer) cash settlement a payout following a credit event in which the protection seller pays the protection buyer an amount calculated as equivalent to the par value of a deliverable obligation less a recovery rate. This amount is determined by the calculation agent, usually by a dealer poll of the price of an obligation collateralised debt obligation (CDO) an investment collateralised by or referenced to a diverse portfolio of debt. The investor is exposed to losses above and below certain thresholds (in the case of synthetic CDOs) or once more junior classes of notes absorb losses (in the case of cashow CDOs) constant maturity credit default swap a credit default swap with a premium reset periodically with reference to the prevailing spread of the underlying credit copula a statistical tool describing how the distribution of single risks join together to form joint risk distribution. In the case of portfolio credit risk, copulas describe how patterns of individual default risk join together to form the distribution of loss on a portfolio correlation see asset correlation. Correlation is usually measured as a percentage, with 100% representing perfect correlation, 0% no relationship and 100% perfectly negative correlation correlation smile a phenomenon whereby junior and senior tranches imply high correlation and mezzanine tranches imply low correlation credit default swap an over-the-counter contract to transfer credit risk, in which the buyer of protection pays a premium and the seller of protection makes a payment in the event of default. delta the sensitivity of a derivative such as an option to changes in the reference price. In index tranches, the sensitivity of the tranche to changes in the price of the underlying names. Also known as convexity detachment point also known as exhaustion point, the maximum level of losses in the portfolio to which a tranche is exposed exchange traded fund a basket of stocks or bonds traded on an exchange that reect the composition of an index. It trades like a single stock and can be sold short

glossary 47

first-loss tranche the most junior tranche in a CDO or, more generally, a tranched portfolio credit derivative with an attachment point of zero rst-to-default basket see nth-to-default basket fpml a set of standards for describing the terms of a nancial instrument designed to facilitate trade processing futures contract an agreement to buy or sell a set amount of a commodity or security for acceptance or delivery in a designated future month at a price agreed on today implied correlation the expected correlation of defaults in a portfolio derived from the price of a tranche and the price of the underlying credits implied volatility the expected volatility in the return of an asset derived from its option price index tranche a credit default swap referencing an index between standardised attachment and detachment points nth-to-default basket a credit derivative in which the payout is linked to one in a series of defaults (such as rst-, second- or third-to-default), with the contract terminating at that point over-the-counter (OTC) derivative a privately negotiated derivative contract between two counterparties, as opposed to a standardised contract traded through an exchange payer option an option to buy credit default swap protection physical settlement a payout following a credit event in which the protection buyer delivers an eligible obligation to the protection seller in exchange for the par value of the asset protection buyer the counterparty that hedges credit risk in a credit derivative protection seller the counterparty that assumes credit risk in a credit derivative put option an option contract giving the owner the right, but not the obligation to sell a specied amount of an underlying security at a specied price within a specied time. For credit default swap options, a put option can be a put on risk (payer) or on protection (receiver) receiver option an option to sell credit default swap protection reference entity the borrower whose default triggers a payout in a credit derivative skew also known as smile, the variation in an implied variable such as correlation or volatility across dierent strikes, maturities or attachment points straight-through processing the automated processing of trades from front oce (trading) to back oce (settlement) subordination the amount of losses a portfolio has to experience before a tranche suers any loss super senior a tranche that benets from subordination that is implicitly or explicitly rated triple-A

48 credit index trading

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