In the early days of the credit derivatives market, pinning down precise figures for the volume outstanding in the CDS market was notoriously difficult, with trading conducted over-the-counter rather than via an exchange, and banks and other intermediaries reluctant to reveal much detail about their activity in the market.

That partly reflected the fact that the CDS market originally evolved as a successor to a series of informal, privately tailored agreements between banks and their customers. Indeed, participants report that in contrast to, for example, the Eurobond market (which has a readily identifiable start date of 1963, when Autostrade launched the first Eurobond) it is impossible to pinpoint precisely when the CDS market was inaugurated.

Although as recently as June 2001 the Bank of England was reporting that “comprehensive, global data [on the size of the credit derivatives market] do not exist”, it is self-apparent that information on the size, structure and historical evolution of the market is now much more readily available than it has ever been, with the British Bankers’ Association (BBA) having collated figures on the sector since the mid-1990s.

According to that data, the global credit derivatives market was worth $180 billion in 1997. Thereafter it expanded rapidly, to $350 billion in 1998, $586 billion in 1999, $893 billion in 2000 and $1,189 billion at the end of 2000. Historically, according to the BBA figures, so-called single-name CDSs have comprised the largest share of the overall credit derivatives market, although their share fell from 52% in 1997 to 45% in 2001, reflecting the increased diversification and sophistication of the market. In addition to the absolute figures, the BBA compiles statistics giving important insights into which market participants are the most active in terms of buying and selling protection, as well as forecasts on the outlook for the market.

Other valuable sources of information on the size of the credit derivatives market are Isda itself and the Office of the Comptroller of the Currency (OCC) in the US, which “charters, regulates and supervises national banks to ensure a safe, sound, and competitive banking system that supports the citizens, communities and economies of the United States”.

The OCC started to compile data on the credit derivatives positions of US commercial banks in early 1997, and its statistics put the modest size of the credit derivatives market into vivid perspective. According to its third-quarter review published in December 2002, “86% of the notional amount of derivative positions was comprised of interest rate contracts with foreign exchange accounting for an additional 11%. Equity, commodity and credit derivatives accounted for only 3% of the total notional amount.”

According to the BBA’s 2001/2002 analysis, London continues to be the dominant centre in the global credit derivatives market, well ahead of New York and the fragmented Asian financial centres, with a limited amount of trading taking place in Tokyo and Sydney. In terms of market share, the BBA advises, London accounted for 49% of the global market in 2001. It forecasts that the London credit derivatives market will grow to $2,450 billion by the end of 2004, giving the City a global market share of about 51%.

Trends in underlying assets

Since the emergence of the credit default swap market in the mid 1990s, there has been a noticeable shift in the types of assets on which protection has been sought. According to the BBA, in 2001 only 15% of products were written on sovereign assets, down from 46% in 1996 when it first conducted the survey. “The vast majority of credit derivatives are now written on corporate assets, with 60% of credit derivatives written on the asset class in 2001,” the BBA noted. “This trend is expected to continue in 2004.” That trend, of course, reflects the vastly increased size of the corporate bond market since the mid-1990s, as well as the deterioration of credit quality that gathered momentum between 1996 and 2001, prompting lenders and investors to seek increased levels of protection.

More specifically, research published in March 2003 by rating agency Fitch identifies the most actively traded CDS as being for reference entities that are also the most prolific issuers in the underlying cash bond market, but in which the probability of default is remote in the extreme. According to the Fitch data, the most commonly cited reference entities among respondents to its survey were General Motors, DaimlerChrysler, Ford, General Electric and France Télécom.

Beyond these credits, bankers confirm that the diversification of corporate names being traded in the CDS market is on the rise. As a report published by Dresdner Kleinwort Wasserstein (DrKW) in November 2002 notes: “According to our credit derivatives desk, around 500 credits, mostly investment grade, are now actively traded.” The same report adds that “the industry distribution is relatively even, with industrials the dominant sector followed by financial services and banks”. This degree of relative diversification within the CDS market in Europe is in marked contrast to the underlying cash market, in which a handful of industries continue to account for a disproportionately high share of the most actively followed benchmarks.

For example, according to the figures published by DrKW, as of late 2002, outstanding bonds issued by telecoms companies accounted for 20% of the iBoxx euro corporate bond index, but for only 5% of outstanding CDSs; for autos, the shares were 14% and 4% respectively; and for banks, 20% and 6% respectively. Conversely, while at the same date industrial issues accounted for only 8% of the iBoxx index, they represented 20% of the CDS market.

Growth prospects

In its third-quarter review for 2002, the Office of the Comptroller of the Currency reported that the notional amount of credit derivatives reported by insured commercial banks increased by more than 16%. That is a very appreciable rate of growth, and would appear to support the estimates of those who believe the global market will continue to expand at breathtaking speed over the next few years. One of those forecasts, made by the BBA, is that the total market will reach what it describes as a “staggering” $4.8 trillion by 2004.

That rate of growth, advises the BBA, could become even more dramatic if and when various uncertainties and legal impediments to the market’s expansion are removed. “Regulatory uncertainty, for instance over the outcome of the Basel II negotiations, constitutes one of the major constraints to the growth of the credit derivatives market,” noted the BBA.

For the time being the jury is out on how the Basel II guidelines on bank capital will affect the credit derivatives market. The principal element of Basel II is that it will impose a risk weighting of 20% for assets rated triple-A to double-A, 50% for those with a single-A rating, 100% for triple-B to double-B rated assets, 150% for those rated below double-B and 100% for unrated assets. The proposed new guidelines, which the BIS describes as being based on a “more risk-sensitive framework”, are intended to “leave the total capital requirement for an average risk portfolio broadly unchanged”. How much of an impetus these measures will have on encouraging participants in the credit market to search for more protection on their exposure is open to question.

However, bankers point out that in sharp contrast to, say, the market for interest rate and currency swaps, the potential for the addition of new reference entities in the credit derivatives market represents what is almost a bottomless pit, given that CDSs can be written on any borrower in the bond or loan markets, and that the universe of issuers is constantly expanding.

Liquidity

In the immediate aftermath of the Enron crisis at the end of 2001, while liquidity in the cash bond market dried up dramatically, activity in the CDS market remained resilient. Bankers reported that, in turn, this strength in the CDS market helped liquidity to return to the cash market more quickly than would otherwise have been the case, given derivatives’ capacity to allow traders to express long and short views on individual credits.

The liquidity and transparency of the CDS market has improved dramatically over recent years as an increasing number of intermediaries have entered the market, quoting indicative two-way (bid and offer) prices for the more actively traded corporates and sovereigns on their websites, as well as on electronic data vendor screens. While those spreads are frequently much wider than those quoted on the underlying cash market, the availability of transparent prices is an important step forwards for the CDS market.

The transparency of the market has also been substantially enhanced by credit derivatives brokers such as GFI, which was founded in 1987. GFI’s credit derivatives data collection includes traded levels as well as bid and offer prices for sovereign and corporate entities from all regions and market sectors. The data is made up of almost 300,000 price points across 1,700 reference entities dating back to 1997, and is made available to subscribers via a web-based portal.

“By nature, our credit default swap data provides a forward insight into credit trends before most other indicators,” GFI explains. “This can be used to mitigate credit risk, measure market concentration risk in credits, industries and companies, and maintain a daily market perspective on credit quality across a wide universe of names. In contrast, most other methods rely on historic rates of recovery…and are therefore backward looking and do not reflect current market trends.”

Another helpful initiative in terms of liquidity and transparency was the launch of Mark-It Partners in 2001. At launch, the firm explained that “the demand for definitive, transparent credit information is intensifying. Until now, finding data that combines accuracy, range and ease of use has been impossible.” Mark-It describes its service as one that is “revolutionising credit pricing”. The firm offers a “ground-breaking credit pricing concept that offers a total on-line solution for today’s market”.

Understanding the basis

The difference between the CDS market price and the credit spread on cash bonds is known as the ‘default cash basis’ or the ‘default swap basis’ – and this ‘basis’, which in the majority of cases is positive, can and does vary appreciably depending on a range of technical and fundamental market circumstances. As a result, exploiting the difference between CDS and cash bond prices, known as ‘trading the basis’, can be a highly effective arbitrage strategy and has become especially popular among hedge funds.

Please email Matthew Attwood, Editor, to comment on this article.