Electronic trading of credit derivatives is well established in the dealer-to-dealer arena; now it is the turn of the dealer-to-client arena to make the leap from phone trading to e-trading. But as Saskia Scholtes reports, there are fears that the infrastructure is not yet in place to be able to cope with large volumes of such trades
Over the past several years, the evolution of the credit derivatives market has
been nothing short of extraordinary. By year-end 2004, notional volumes outstanding were approaching the $8.5 trillion mark, according to the International Swaps
and Derivatives Association (Isda). The prospect of capturing a slice of this burgeoning market has prompted the launch of a number of electronic credit derivative
trading platforms in recent years.
The large majority of these are broker-run dealer-to-dealer platforms such as RealTime, run by credit derivatives broker Creditex; CreditMatch, operated by
GFI; and BrokerTec, a general online broker-dealer platform run by Garban-Icap on which credit default swaps (CDS) can now be traded. In the dealer-to-client
arena, traditional voice trading has remained the norm, with only two single-dealer proprietary electronic platforms run primarily out of Europe by BNP Paribas and
Barclays Capital.
During the second half of this year, however, dealer-to-client credit derivatives trading will become possible on two new multi-dealer electronic platforms currently
under development. The companies in question are Thomson TradeWeb, an online fixed-income trading network, and MarketAxess, an operator of an electronic trading platform
for US and European high-grade corporate and emerging market bonds. The two new platforms will both provide auction-based pricing, execution and straight-through
processing (STP) capability for the investment-grade and high-volatility Dow Jones CDX and iTraxx indices.
MarketAxess and TradeWeb say they are responding to a growth in the number and type of clients making use of credit derivatives, which has been particularly
rapid since the merger of the Trac-x and iBoxx synthetic indices in April 2004, and a need for faster execution and trade confirmation. But while dealers and
clients are likely to respond to the benefits of efficient execution and STP, some market participants warn that developing reliable STP for the dealer-to-client
space will be an uphill battle.
Be careful what you wish for
The fastest-growing and most involved group of clients in the credit derivatives market are hedge funds. Richard Cohen, managing director of the strategic investments
group at Banc of America Securities, says, “We’re seeing a growing breadth of customers that are using the product for a variety of purposes. Financial institutions have traditionally used credit derivatives for hedging purposes, but the hedge fund community has used it for a number of hedging, risk transfer and cross-product arbitrage purposes.” Hedge funds have doubled in size and number since the year 2000, according to consultancy Hedge Fund Research.
In 2004 alone, around 400 new hedge funds were created, bringing the known total to 7,000.
But since the creation of the Dow Jones CDX index series out of the Trac-x/iBoxx merger, other more traditional money managers are tapping the market too. Lisa
Watkinson, global head of structured credit product management at Morgan Stanley, says that the breadth of participation is a reflection of familiarity with the
product, better-quality market data and standardization of terms.
“The investment-grade CDX index is not too dissimilar to the S&P 500 for equities in that if you want to get involved in credit, it’s the cleanest,
easiest way to do it,” says Watkinson. “So it’s not just the so-called fast money getting involved, we have clients from every walk of life:
traditional money managers, insurance companies, banks, issuers, as well as hedge funds.” In terms of notional volumes, Watkinson estimates that the
ratio of index trades to single-name CDS trades is somewhere in the order of eight to one.
George Harrington, credit derivatives market manager at TradeWeb, argues that the most important driver of this growth in volume and investor participation
has been the standardization of the index market. “Standardization in the CDS index market and the fact that contracts are fungible has created the environment
where existing contracts can be assigned or collapsed with relative ease. That has led to an explosion in volumes, with the index market now experiencing daily
global trading volumes that often exceed $30 billion in terms of notional principle.”
However, the rapid growth in front-office trading volumes has created processing backlogs for the middle and back offices at many firms. In some cases, signed
trade confirmations are taking as long as 60 days to complete, something that Jonathan Graves, a trader in fixed income at Barclays Global Investors, knows
only too well.
“I’ve heard that, seen that and experienced that,” he says. “It takes capable back-office people to keep it rolling because of the over-the-counter
nature of the market. Processing is improving but at the same time volume is increasing too, so it’s hard for them to stay ahead of the curve.”
The average weekly number of credit derivatives trades rose from 283 last year to 644 and average monthly settlements more than doubled from 2,042 to 4,960, according to an Isda operations benchmarking survey released in June.
Barry Goldenberg, head of product management and development at MarketAxess, adds that not only has the growth in trading volumes been astronomical, but
standardization has led to a huge increase in the number of assigned transactions from new trades, particularly in the index space. Assignments occur when a client
exits a position by selling the trade to another counterparty. “In many cases, dealers are not always certain of how many unconfirmed trades they have outstanding as assignment details are not always communicated on a timely basis.
Often, this information is only discovered when there is a break on the coupon payment date.”
Harell Smith, manager of the securities and investment practice at financial consultancy Celent, says the problem all comes down to paper. “It’s
really horrifying to think that to this day, most of the process of confirming
allocations is done by fax. I think the ultimate goal would be for settlement to be done on an exception management basis: firms would essentially settle trades automatically and only bring in office personnel when there is a mismatch.”
The processing problem has not escaped the attention of the regulators, who view it as a matter of operational risk. Earlier this year, UK regulator the
Financial Services Authority voiced concerns at the high level of unsigned confirmations outstanding between CDS counterparties, with certain transactions remaining
unconfirmed for months. And in April, Timothy Geithner, president and chief executive officer of the Federal Reserve Bank of New York, expressed some of
the same concerns at a Bond Market Association conference.
“The rapid growth in the trading of credit default swaps and structured products has resulted in considerable back-office backlogs—unsigned confirmations
and master agreements, delays in trade capture into risk management systems, delayed notification of assignments of positions—that create significant
operational risk for market participants,” said Geithner.
Improving the process
Industry initiatives to speed up the trade confirmation process are already under way and making good progress. Robert Pickle, chief executive officer and executive director of Isda says, “The industry has made a significant commitment to tightening up its post-trade processing performance and is reaping the benefits of these efforts most notably in credit derivatives.”
Automated generation of credit derivatives confirmation has increased to an average of 40% from 24% last year, while the number of credit derivatives confirmation
backlogs dropped significantly, according to Isda’s operations benchmarking survey. The delay for signed confirmations was reduced from an average of 17.8
business days last year to 11.6 days in this year’s survey and error rates for front-office processing of trades was reduced from an average of 18% to
9% this year.
Cohen at Banc of America Securities says, “The trade confirmation process is still evolving but there is a very good story to tell about the industry’s
rapid adoption of new post-trade technologies. It depends whether you see the glass as half full or half empty, but looking at the Isda statistics, I think
it’s a pretty commendable industry effort to get that far in less than 18 months.”
Market participants explain that since credit derivatives are long-term contracts,
developing STP for the CDS market goes beyond the ability to match new trades in real-time, it also involves cashflow reconciliation, bilateral cashflow netting,
portfolio reconciliation tools, as well as the ability to terminate blocks of transactions across multiple counterparties.
Joseph Sack, executive vice-president at the BMA, says, “When trades are done by telephone and confirmations are manual, we’re still living in an
era where real-time is not fast. One of the benefits of moving to e-trading
is that trades are locked in and confirmations happen in real-time.” As a result, explains Cohen, the growth in the business has put added pressures
on getting the technology adopted as rapidly as possible, “because in order to scale your business, you have to be efficient from a post-trade processing
point of view.”
MarketAxess and TradeWeb hope to help address this need for fast and efficient confirmations by offering straight-through processing on their platforms: MarketAxess
in partnership with the Depository Trust and Clearing Corporation (DTCC) and TradeWeb via its existing STP product, TradeXpress.
Rick McVey, chief executive officer of MarketAxess, says, “There is a capacity issue in the CDS market because of the rapid growth. Dealers and investors alike
have a vested interest in promoting efficiency through technology solutions to increase capacity and control in the CDS business. We are creating a direct
link to the DTCC so we can help these industries move to ‘T plus zero’
confirmations.”
Investors and dealers contend that one of the major advantages of STP is that, rather than spending time picking up pencils and sending faxes to take care
of trade confirmations, automated processing will allow CDS traders to spend more time on the value-added for their clients. Morgan Stanley’s Watkinson
says, “We think that this will be powerful for all users of derivatives.
At the moment salespeople and portfolio managers are spending time on execution paperwork, but with automated processing, they’ll be able to devote that
time to thinking about and discussing alpha-generation ideas.”
The challenge ahead
The development of electronic trading for the dealer-to-client credit derivatives market is undoubtedly an attractive proposition, not just for MarketAxess and
TradeWeb, but also for dealers and their clients who will benefit from greater transparency, multiple sources of pricing and the efficiencies associated with
straight-through processing.
In addition, the very factors that have encouraged investors to get involved in the index market suggest a level of maturity that indicates an environment
ripe for e-trading, says Sunil Hirani, chief executive officer of interdealer
broker Creditex. “The product has become very liquid, with tight bid-offer spreads and continuous markets in indices, and it’s also very standardized,
which is important,” explains Hirani. “We now have automization standards in FpML [Financial Products Markup Language], the Isda framework and standardization
of reference obligations in Red [Reference Entity Database]. These are all very good ingredients for e-trading and e-processing.”
However, Hirani argues that developing a robust and reliable STP platform in this complex market, and particularly in the dealer-to-client space, is a weighty
challenge. “I think dealer-to-client e-trading is a bit like putting the cart before the horse, the horse in this case being efficient electronic processing
of transactions. To have truly effective dealer-client e-trading in place, you need to have the electronic processing infrastructure in place and we’re
not there yet.”
Market participants explain that the added difficulties of trading and processing for a dealer-to-client platform are many and various, not least in terms of
untangling the counterparty credit risk issues around contracts with asset managers as opposed to dealers. Jack Mahoney, director of research and marketing at Thomson TradeWeb, explains that dealers may be executing a single trade with a large institutional fund manager, “but that trade may be taking place on behalf of multiple sub-accounts, all of which have their own credit agreements. If you look at the number of sub-accounts in aggregate across the asset management community, then you see how it can get exponentially more complicated every time you trade.”
Kip Testwuide, the New York-based head of sales and origination at BNP Paribas, adds, “There are many more complexities in developing a dealer-to-client
platform for credit derivatives because you have a multitude of investors with numerous accounts, credit agreements and collateral issues. In order for such
a platform to be scalable, it has to be flexible, which is why it is taking a little longer to develop.”
Market participants are hopeful that the platforms will eventually offer trading capability on the remaining indices and in single names, but stress that it is crucial to have all the parts in place for STP first. As one credit derivatives
dealer explains, “We cannot build a Ferrari without brakes, or without airbags. We believe that index trading on an e-platform will increase volumes,
so we want to get that right before we try to expand the offering.”
However, both MarketAxess and TradeWeb say that they are confident of developing solutions with that flexibility, so that when the market is ready for e-trading
on the less liquid indices in high yield and emerging markets, or even in the single-name space, the platform can be scaled to meet that demand. Jim Toffey,
chief executive officer of Thomson TradeWeb, says, “We didn’t build this overnight for CDS; we’re working hard to leverage all our existing
expertise in STP over the last three years.”
In the meantime, investors and dealers are looking forward to the launch of the platforms, describing it as a win-win situation for them, contributing to
faster execution and providing the potential for increased growth in volumes and in client participation. Len Jardine, head of US sales and credit research at BNP Paribas, says, “We’re looking to get more real-money accounts
into this product and I think that e-trading will be a boon for that. It will not only help to standardize back-office procedures, but also increase the product’s
legitimacy by having it trade side by side with corporate securities, removing some of the element of mystery around CDS.”
