The credit derivatives market is one of today’s mostimportant over-the-counter markets. The growth of themarket has outperformed all expectations, rising from anotional value of $5 trillion in 2004 to over $20 trillion in2006, according to the British Bankers Association. Thisphenomenal growth in the size of the market has beenmatched and to some extent driven by the array of newcredit derivative products; index trades, tranched indextrades and options on credit default swaps to name justa few. Furthermore, the market is soon to enter the nextphase of its evolution, exchange-traded credit derivativefutures. On March 27, Eurex is set to launch the world’sfirst exchange-traded credit derivatives contract, a futurebased on the Itraxx Europe index, the most widely tradedindex in the over-the-counter market. Depending on mar-ket demand and sufficient OTC market maker support,Eurex will also list futures contracts on the Itraxx HiVoland Itraxx Crossover indices, either simultaneously onMarch 27 or soon after.

Countdown to Credit Derivative FuturesAre Exchange-Traded Futures Poised to Revolutionize the Credit Derivative Market?By Fiona Pool and Betsy Mettler

30 Futures Industry

This push into exchange-traded creditderivatives is not limited to Europe; the

Chicago Mercantile Exchange’s proposal totrade futures on single name credit defaultswaps has recently been approved by theCommodity Futures Trading Commission.An exact launch date has not yet beenannounced but it is expected to start tradingin the first quarter of 2007. The ChicagoBoard of Trade and the Chicago BoardOptions Exchange are also planning theirown product launches in the near future.Given the spectacular growth in the creditderivatives market, it is unsurprisinglyattracting interest from all corners of thefinancial community.

In the BeginningIn analyzing the potential demand for

credit derivative futures, it is important tounderstand the origins of credit derivatives.In the mid-1990’s financial institutions real-ized that although they had strong relation-ships with borrowers and had the best accessto cash, they were not necessarily efficientholders of credit risk due to their regulatorycapital requirements. They needed to sepa-rate the credit risk of these loans from thefunding risk. If this could be achieved, finan-cial institutions would be able to retain theirrelationships and continue to provide loansto their clients but not retain all of the

credit risk. Effectively they wanted to buyprotection from a third party against a bor-rower default. This initiative took the mar-ket by storm and so was born the creditderivatives market. Since these creditdefault swaps allowed the isolation andtransfer of credit risk from one party toanother, CDS volumes exploded. Not onlywere banks able to offset their traditionalcredit risks, but investors now had access tocredit risk that had previously only residedin the bank loan market. This ability to tai-lor credit exposure to the specific needs ofinvestors, dealers and portfolio managers hasbeen the driving force in the growth in thecredit derivatives market.

A natural progression from single namecredit default swaps was the development ofCDS indices. The launch in 2004 of theiTraxx in Europe and CDX in the UnitedStates created a standardized series of indicesthat revolutionized the credit markets byallowing investors to take macro views onthe broader credit market.

Who’s Who in Credit Derivatives

Banks still constitute the largest marketparticipant but there has been a shift inemphasis from the loan portfolio desks to themarket-making trading desks, with thetraders now representing almost two thirds of

banks’ derivative volumes. According toFitch Ratings, the top ten OTC market mak-ers accounted for 86% of traded volume in2005. Morgan Stanley, Deutsche Bank,Goldman Sachs, and JPMorgan have consis-tently been the top four OTC market makersand between them constitute the lion’s shareof derivative volumes. Although banksremain the largest market participant, their

market share has fallen over the last fewyears. Hedge funds have continued theirdrive into the credit derivatives market,expanding their market share of buyers ofprotection to almost 30% in 2006. But theirgrowth is most exceptional as sellers of pro-tection, unsurprising given the lack of liquid-ity in the cash markets and the search forinvestment opportunities.

n to Credit e Futures

Revolutionize the Credit Derivative Market?

March/April 2007 31

Source: BBA - Credit Derivatives Report 2006

Global Credit Derivatives MarketIn $ billions of notional value

With greater liquidity in credit deriva-tives, many more asset managers are nowusing the indices as part of their overall riskmanagement and investment policy strat-egy. But the primary application of creditderivatives has been and remains for tradingand market-making purposes. According tothe BBA report, the average traded volumeof European indices in 2006 was $182 bil-lion, up from $125 billion in 2005. Indextrades now account for approx 30% of over-all credit derivative transactions and

together with single name credit defaultswaps they account for over 60% of allcredit derivative transactions. Market par-ticipants expect this strong trend of growthin indices to continue.

Settlement procedures have alsoevolved over the last few years; physical set-tlement remains the principal payoutmethod following a credit event, but itsmarket share, according to the BBA, hasdropped from approx 85% in 2004 toaround 70% in 2006. Cash settlement has

increased its relevance to approximately25% of all payouts in the last two years.Interestingly, a fixed payout structureremains the least favored method of settle-ment as it is difficult for investors to predictrecovery rates and hence potentially leavesthem exposed to further losses.

The trading of CDS in the inter-dealermarket has been facilitated with the devel-opment of electronic trading platforms.Creditex was one of the first to successfullylaunch an electronic platform for theiTraxx index in Europe several years agoand is now widely used in the OTC dealercommunity. Straight-through processingwill allow the entire trade process to beexecuted electronically. It is still in earlydevelopmental stages but when fullyimplemented, it will streamline the confir-mation and assignment process, which iscurrently manual.

Trouble in Paradise?The development of this market has

not been without problems, mostly stem-ming from its own product complexity.Firstly, there have been legal issues sur-rounding CDS documentation such aswhat actually constitutes a credit event aswell as which reference entity’s bonds orloans are deliverable in a credit event.Other issues surrounding documentationand settlement are also not insignificant:counterparty risk, ISDA agreements, col-lateral posting, administration and opera-tional costs, as well as pricing and thedifficulty of obtaining a daily mark-to-mar-ket on OTC contracts. But the biggestdilemma for this market has ironicallystemmed from its own success. As the mar-ket took off, the sheer mass of trades beingexecuted created a huge backlog of uncon-firmed trades, a problem that the regulatorssaw as a major risk in destabilizing theeffectiveness of this market. According tothe BBA 2006 report, almost 10% of tradeswere more than two months late in beingconfirmed.

In 2005 both the Federal Reserve Bankof New York and the Financial ServicesAuthority took the unprecedented step ofcontacting senior bankers and urging themto take action to reduce this backlog. Twoyears on, much has been done to alleviatethe pressure of unconfirmed trades butproblems remain. According to a recentFitch Ratings report, settlement followinga default and trade confirmation remainthe biggest challenges facing the creditderivatives market. With the launch of

32 Futures Industry

What Is a Credit Default Swap?A Credit Default Swap is a form of protection against credit risk. It is a bilateral contract

whereby the credit risk of a reference entity (the issuer i.e. Ford) is transferred from the protec-tion buyer to the protection seller. The protection buyer pays a fixed premium to the protectionseller in return for a contingent payment, which compensates the protection buyer for any lossincurred in case of a Credit Event. The standard corporate credit events are bankruptcy, failureTo pay and in some cases, restructuring. If no credit event occurs during the life of the CDS con-tract, the protection buyer continues to pay the premium until the maturity of the contract andthe protection seller does not have to make any payments. If a credit event does occur, standardmarket contracts physically settle, whereby the protection seller pays the protection buyer thenotional value of the contract in return for the defaulted bonds or loan with a face value equal tothe notional value of the contract.

Single Name CDS

After a Credit Event

Source: JPMorgan, B&B Structured Finance

exchange-traded credit derivatives, theexchanges aim to provide a cleaner, moreefficient way of trading credit risk. Inessence, they hope to alleviate many of theproblems facing the OTC market andensure full transparency of the product andpricing mechanisms.

Eurex’s CoupEurex jumped ahead of the other

exchanges in 2005 when it secured therights to license the iTraxx indices. Eurexsubsequently sought advice and input fromthe OTC dealer community when design-ing the futures contract. As a result, the

iTraxx credit futures will closely mimic therisk structure of CDS traded in the OTCmarket. The contract will be based on the5-year series with a fixed coupon and semi-annual maturity dates, March andSeptember. Contract size is €100,000 andthe tick size is set at 0.005%, which equals€5 per tick. The future will be cash settled,with the settlement price reflecting theiTraxx index value determined by theInternational Index Company, the indexprovider. In the case of a credit event, theexisting credit futures contract will con-tinue to trade, but Eurex will list a separatefutures contract based on the new versionof the underlying index with the affectedentity removed. Settlement of thedefaulted single name CDS will be madewith reference to the ISDA CDS protocolwith the timing of its settlement dependenton when a recovery rate is set.

A major hurdle for Eurex will be gain-ing the support of the OTC dealer commu-nity. When talks were first initiated withthe IIC and the OTC dealer communityseveral years ago, the iTraxx was in itsinfancy and it was not obvious just howhuge this product would become. So thedealers were keen to discuss any potentialavenue to expand their market and ulti-mately their revenues. Since then, theindices have been embraced by fixedincome dealers, investment banks, largehedge funds and many regional banks inorder to speculate on the credit market andhedge their portfolios. Liquidity runs deepwith single trades sometimes running intothe billions. Competition for investor busi-ness among the OTC market makers isintense and tight bid-offer spreads havereduced dealers’ profit margins consider-ably. As a result, this part of the market isconsidered a fairly “plain vanilla” product,and one can see why Eurex would see themarket as ripe for the introduction of anexchange-traded derivative on the index.But with daily trading volumes in theiTraxx reaching €25-30 billion, Eurex hasits work cut out for it in matching the liq-uidity of the underlying.

Many of the top OTC dealers are skepti-cal of the need for credit derivative futures. Itis possible that the OTC dealers with asmaller foothold in index trading will be thefirst to embrace the iTraxx future in order toincrease their trading volumes. Most futuresdesks are supportive of the product, but itwill be the OTC index traders who will tradethe future and provide liquidity. Without thesupport of the top OTC dealers, credit deriv-

36 Futures Industry

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

2000 2002 2004 2006

Banks Hedge funds Pension funds Corporates

Insurers Mutual funds Other

0%

10%

20%

30%

40%

50%

60%

70%

2000 2002 2004 2006

Banks Hedge funds Pension funds Corporates

Insurers Mutual funds Other

Sellers of Credit Protection

Buyers of Credit Protection

Source: BBA – Credit Derivatives Report 2006

ative futures are unlikely to give the OTCcontract a run for its money, at least in theshort term.

An Untested MarketMany market players are concerned

with the timing of the launch, given the rel-ative immaturity of the underlying market.There have been many changes andimprovements in CDS contracts over thelast 10 years, and it is likely we have notseen the last of any structural changes in theOTC contract.

One major concern is the fact that theISDA settlement protocol has never beentested in Europe. The European creditmarket has been buoyant for the last fewyears, and it is not clear what would hap-pen in the face of a major default. It isexpected that the market would replicatethe same ISDA protocol as used in theU.S. but since this has not been tested yet,some are cautious.

Potential OTC settlement issues follow-ing a credit event were highlighted in theU.S. with the bankruptcy of Delphi in 2005.Given the demand from protection buyerslooking to source bonds and speculatorsanticipating a short squeeze, the price ofDelphi bonds rose considerably immediatelyafter bankruptcy. This radically distorted thefinancial payout of the original derivativestrade and caused disorder in the cash market.

The Delphi situation was intensified bythe very large notional exposure in the formof single-name CDS, index trades and syn-thetic collateralized debt obligations relativeto the notional amount of deliverable bondsoutstanding. If protection buyers could notsource enough bonds to deliver to protectionsellers, they ran the risk of not receiving theircontingent payment.

Since the growth in the credit deriva-tive market is effectively unlimited due tothe synthetic nature of many credit deriv-ative structures, these settlement issuesneeded to be addressed. Now that theoption of a cash settlement procedure hasbeen incorporated into the ISDA proto-col, such derivative trades should performas expected.

There is also concern that the ISDA pro-tocol does not address the settlement issuesthat surround a restructuring credit event,one of the standard credit events in theunderlying iTraxx index. All are issues thatlead one to question whether the broaderinvestor base will want to see a more stableOTC contract before taking risk exposure viathe Eurex future.

On the flip side, the benefits of a stan-dardized exchange-traded contract are evi-dent: no counterparty risk, no ISDAagreements, no novation issues, efficienttrading and execution, a totally transparentpricing mechanism, a daily mark to market,not to mention the freeing up of valuablecredit lines.

Several factors will determine howquickly current iTraxx users switch to trad-ing the future. Liquidity will be the primaryfactor but there are also the issues of exist-ing positions, having to re-hedge one’sentire portfolio every six months as thefuture expires plus the comfort of sticking towhat one knows works. Eurex’ successhinges on tapping into a new set of partici-pants, in particular asset managers andinvestors facing hurdles to trade the OTCcontract. Barriers to entry in terms of theamount of infrastructure that is requiredhave meant many managers are simply notusing the OTC instruments. Perhaps thecredit futures price transparency and ease oftrading may be the catalyst many investorshave been looking for. But how deep doessuch demand run? Although the creditderivatives market has seen phenomenalgrowth over the last five years, their use isconcentrated amongst the most sophisti-cated of investors. How educated is the

broader investor community within thecredit derivatives space and how comfort-able will they be in taking credit exposurein such a way? These questions highlightand articulate what is seen as a major con-straint for the future growth of the globalcredit derivatives market, namely educationof the investor space.

Deeper Waters in the U.S.This issue is even more prominent when

considering the U.S. market. Although thecredit derivatives market was initially devel-oped in the U.S., innovation in CDS overthe last five years has been driven by Europe.Perhaps given the size of the U.S. credit mar-ket, dealers and investors alike have not feltthe need to embrace new products in thesame way as their European counterpartshave. With the U.S. being a very dealerdriven market, the U.S. exchanges may findit even harder therefore to penetrate themarket in the early stages.

Despite plans to merge, the CME andCBOT are still operating as separate entitiesand have chosen to pursue separate strate-gies. The CME will list a credit derivativefuture on single name CDS, referencing justthree entities at launch: Jones Apparel,Tribune and Centex. The CBOT favors theindex route, but has not disclosed any details

March/April 2007 37

Product Type Breakdown

Source: BBA – Credit Derivatives Report 2006

of its plans yet. The CBOE also intends tolaunch credit default options on up to 10 sin-gle names, and is seeking regulatory approvalfrom the Securities and ExchangeCommission.

Each of the U.S. exchanges’ proposalsdeviates significantly from the standard OTCcontract. The CME initially included all sixevents under ISDA 2003 documentation(failure to pay, restructuring, bankruptcy,obligation default, obligation acceleration ordebt payment moratorium) but in January itrevised the proposed contract design to coverjust one type of credit event. The CBOE out-lines failure to pay as well as other creditevents it may chose to include. Aside fromcredit events themselves, the proposed pay-outs as a result of a credit event differ too.The CBOE elects a 100% payout while theCME has chosen a set 50% recovery rate.

Is the key to suc-cess to replicate theunderlying OTC con-tract, as Eurex hasdone? Or is it todevelop a whole newproduct based looselyon the underlyingOTC market but withseparate, distinctterms and conditions, as the U.S. exchangesare hoping? Two fairly different strategiesbut which will investors embrace? Onlytime will tell.

Aside from specific product issues, it isalso worth considering differences betweenthe U.S. and European markets. As wetouched on earlier, the U.S. is a moredealer-driven market. Without the supportof the OTC dealer community in providingconsistent, tight markets, success will beharder to achieve. In addition, if the com-petition among the U.S. exchanges dividesliquidity, it may hamper the success of thecontracts. In contrast, Eurex is currently theonly European exchange with a creditderivative future ready for launch.Euronext.liffe has plans to create a contractbased on CDS but has not yet submitted aspecific proposal.

Many of the same benefits mentionedfor the index futures product apply to thesingle name credit futures, namely reduc-tion of counterparty risk, settlement ease,streamlined documentation and a transpar-ent market place. Additional hurdles how-ever, may make it more difficult to achievesuccess in the single name space. There arehundreds of reference entities to choosefrom and determining which of these will

most whet investor appetite will be chal-lenging. The CME chose its three specificcredits based on industry sector, the level ofactivity in the five year CDS market andcredit ratings on the assumption that theless creditworthy the name the higher theneed for protection. All very logical but ariskier strategy perhaps than futures on anindex with greater standardization and amore established user base. As investorscontinue to chase yield however, the highyield and emerging market sectors havebecome ever more attractive compared tothe tight spread levels seen in investmentgrade credits. Perhaps the CME’s approachwill indeed yield greater success? On thisnote, several European market participantscanvassed for this article have consideredthe launch of a future on the ItraxxCrossover Index a more shrewd bet than the

investment grade index future given thissearch for yield. While the U.S. exchangeshave approached the CDX consortium ofdealers to attain the right to list indexfutures, they have not yet been successful.Given this, the U.S. exchanges have cho-sen to create single name products in ordernot to miss out on the growth opportunitiesin the credit derivative market.

A Framework for ComparisonAn interesting comparison can be made

between credit derivative futures and interestrate futures. Those in the credit derivativesmarket often look to the interest rate deriva-tive markets to see what the future may holdfor credit. Interest rate derivative marketsstarted at least 10 years prior to credit defaultswaps and have grown exponentially with anestimated $200 trillion outstanding notionalin contracts. There have been many productdevelopments along the way from the simpleinterest rate swaps to the more exotic optionson derivatives, constant maturity swaps,locks, caps, floors and inflation swaps. Thismarket while huge has become more com-moditized. As experienced with the launchof interest rate swap futures in 2001, the lackof early success is not necessarily an indicatorof total failure. OTC dealers were hesitant to

trade for fear of losing margins, clients ortrading volumes. However, over time, theseinterest rate swap futures grew in acceptance.Volumes took off in July 2006 whenGoldman Sachs and Citigroup committed tobecome active futures market makers. In thefirst three months post their inclusion, aver-age daily volume jumped 4.5 times and openinterest over two times. What this highlightsis that without the support of the main deal-ers, liquidity and trading volumes will becompromised but that a futures contract canindeed exist alongside the original underly-ing product.

Looking AheadThe introduction of credit derivative

futures is a crucial part of the credit deriva-tives market’s development. They will pro-vide more liquidity in the market and give

more investors accessto credit and theopportunity to hedge.In fact, the futurescontract should ulti-mately help cultivatethe OTC credit deriv-atives market andbring a larger numberof participants into

the underlying market. No doubt issues willarise but the markets will deal with them andevolve in the way they always have done.Success in terms of volumes may not beimmediate, but that does not mean creditderivative futures will fail. There is nodoubt that the credit derivative marketpresents a major opportunity, but theexchanges have to do more than just hopethey get it right, not only by providing rele-vant products at launch and educating theirclient base but by being able to weather set-backs and adapt to market needs on an on-going basis. Only then will they fullycapitalize on the phenomenal growth ofcredit derivatives. ■

Fiona Pool and Betsy Mettler are partners at B&BStructured Finance, a London-based learning andstrategic advisory business specializing in creditderivatives and structured products. Before joiningB&B, Pool worked at Bank of America, where she washead of high yield sales and trading, and GoldmanSachs, where she was instrumental in setting up aglobal credit trading book. Mettler spent seven yearsworking in credit derivatives at JPMorgan, focusingon the development and distribution of new productsincluding the credit derivative indices.

38 Futures Industry

Several market participants consider the launchof a future on the iTraxx Crossover Index amore shrewd bet than the investment grade

index future given the investors’ search for yield.