| Growth in credit derivatives precipitates settlement problems |
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| 22/07/2007 | |
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The total amount of credit derivatives bought and sold reached nearly $50tr at year end 2006, an increase of 113% reported for the period a year earlier, according to Fitch Ratings. A number of concerns have grown regarding the rapid growth of the market, however, not all of them are related to a possible downturn in the credit cycle. "Settlement and back-office systems are finding it difficult to keep up with the backlog of trades," says Ian Linnell, Head of European Banks at Fitch. "The credit default market is physically delivered. The growing problem is that the credit-derivatives contracts outnumber the outstanding bonds needed for settlement. One solution is for the market to introduce an auction type of system." The strains of the market's growth have surfaced in a number of cases, prompting industry calls for additional delivery time and a change in the price determination protocol for the deliverables, and to have a cash-settlement fallback. In one case involving the settlement of a credit default swap, Deutsche Bank sued Ambac Credit Products and its Assurance Corporation claiming they did not pay for bonds Deutsche said were worth $8m in relation to a Credit Default Swap (CDS) settlement. According to Ambac, the bonds were not delivered on time and so it deemed the contract void. This settlement issue has been plaguing the credit derivatives market especially of late. Nonetheless, survey participants expect the credit derivatives to continue their expansion unabated, with CDOs, Loan-Only Credit Default Swaps and traded indexes cited as the biggest growth vehicles in 2007. Traded indexes are a collection of CDSs. Fitch estimates that £22.2bn of index products were bought and sold by year end 2006 compared to $20bn for CDS. The trend toward lower-quality and unrated products remains intact. About 38% of all credit derivatives referenced at year-end 2006 was either speculative grade or unrated compared to 34% a year earlier and 18% in 2003, a consequence of market maturation and investors' continuing search for higher yields in a spread-constrained environment. "It is still a small market compared to interest rate swaps which is estimated to be at least ten times bigger, so there is still ample room for growth." Fitch conducted its first study in 2001. The survey covers 65 institutions, 44 banks and broker-dealers, 13 insurance and reinsurance companies and 8 financial guarantors. These are some of the most important players in the credit derivatives market. Fifty-five percent of the volume came from North American respondents, with the balance coming from Europe and Asia. For the US and Europe, the investment-grade series were predominant. "The breakdown of the Dow Jones CDX North America series in terms of the total notional amount outstanding at the end of 2006 was 91% investment-grade, 7% high-yield and 2% crossover," concludes the report. "The breakdown of the ITraxx Europe series was similar with 87% in Investment-grade, 4% in high-yield and 9% in crossover. The indexes measured just 0.5% of the entire volume." VB |
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