With the growth of electronic trading of credit derivatives in the B2B (dealer-to-dealer) arena having been nothing short of stratospheric in recent years, the evolution of fixed-income electronic trading continues apace with the arrival of the first multi-dealer electronic credit default swap (CDS) index platforms in the later half of 2005.
Thomson TradeWeb, which launched TradeWeb CDS on 26 October 2005, is the most recent player to address the online market place for iTraxx and DJ CDX trading in the dealer-to-client (B2C) space. Reflecting the need to get the functionality of these new platforms right, TradeWeb has embarked on a beta testing period among several of its customers before it rolls the system out to a whole range of customers.
It is all part of a strategy to offer institutional investors the ability to simultaneously request quotes electronically from multiple dealers, and move seamlessly through the whole trade cycle – from trade execution to confirmation.
Platform providers also believe that standardisation and automation of the dealer-to-client trade cycle through electronic trading platforms will lower barriers to entry for buy-side institutions to enter the CDS market and create new trading opportunities.
There is no denying it is early days for the multi-dealer B2C platforms. And, while no one can accurately predict the future, the CDS market since 2001 has grown at an annual growth of 109 per cent for both single-name and CDS index trading. Notional volumes for outstandings approached the $8.5bn mark globally by year-end 2004, and had reached $12,400bn in the first half of 2005.
A contraction of operational cost and risk for both dealers and investors should be welcome news. There are some forecasts suggesting that 70 per cent of all dealer-to-customer CDS trades will be executed and processed electronically by Q3 2008, bringing with it a significant double-digit decline in the costs of processing CDS tickets over that time horizon.
Running parallel with this, London-based consultancy Z/Yen predicts that CDS processing costs among major dealers today stands at around $233, but could dip below the $100 mark inside four years. At the current rate, the top five dealers spend over $60m p.a. just on operations.
A driver behind the CDS trading innovation among competing platforms has been identifying sufficient customer demand and liquidity for new markets to function. With platform providers able to offer trading of other asset classes, the move towards more multi-asset trading – spanning European Government Bonds, US treasuries, Agencies, Supranationals, Pfandbriefe, US and Euro commercial paper, TBA-MBS, ADNs, US Repo and interest rate swaps - can be viewed as taking a big step forward.
Though single-dealer platforms allow investors to execute transactions directly, with the dealer acting as principal, multi-dealer RFQ systems seek to help customers with price discovery. For players like TradeWeb, part of The Thomson Corporation, the move into offering CDS marks the firm’s 13th online market for fixed income and the second in the growing derivatives market.
Given the significant amount of transparency that is already being provided to the market in other products, benefits to end users should accrue from a screen displaying the composite CDS index price - an average of contributed dealer prices. Not only will CDS market participants have accurate CDS index prices that are integrated into the trading process, but similarly to US treasury trades on TradeWeb, execution levels are expected to be “at or better than” the composite price.
Combining more efficient electronic STP with electronic execution should be welcome news for many dealers confronted by the challenge of ever increasing volumes in the CDS index market.
The latest systems have been developed and built in conjunction with leaders in the industry, whilst at the same time meeting the need to reduce the number of unconfirmed trades outstanding – an area that regulators on both sides of the Atlantic have been keen for the industry to resolve.
Certainly there was reason for concern. Indeed, one of the reasons why the regulators have become much more focused on the CDS market lately is largely due to the explosion in activity fed by the convergence of indices or suites into two families (iTraxx in Europe and DJ CDX for the US). Increased liquidity levels have made the asset class an attractive option to a new profile of investor.
The industry has nevertheless been hard at work seeking to rectify matters. T-Zero’s new post trade processing platform, provides immediate affirmation of key trade terms and facilitation of confirmation between parties on trade date is one example of efforts in the credit derivatives markets.
Another recent development has come with the International Swaps and Derivatives Association’s (ISDA) Novation Protocol, a solution facilitating the transfer of an existing trade to a third party, which saw over 700 firms sign up to it by 25 October. This protocol addresses directly the potential for backlogs and uncertainty associated with the transfer of a party’s position in a privately negotiated derivatives transaction.
Despite this progress, ISDA’s Benchmark Survey of June 2005 revealed that just a third of CDS trades get confirmations generated and dispatched to the dealer’s counterparty for review on a T+1. By T+5, 88 per cent of CDS trades have confirmations sent for finalisation, but still 12 per cent were found to remain outstanding. In addition to “counterparty non-responsiveness” being cited in the survey as main cause of discrepancies and unsigned confirmations, backlogs in processing trades exceeded 13 business days for the average firm and 23 for the largest.
While banks make up a significant proportion of CDS trading – both as buyers and sellers of protection – hedge funds and securities houses have recognised the benefits of trading these instruments. Among various reasons for investing in CDS, achieving incremental returns is cited at the top of the list.
Investing in CDS index instruments also provides a clean and easy way to access the asset class, with the investment-grade CDX index being not that dissimilar in terms of exposure to the S&P 500 for equities. For others it provides a way of expressing a pure – negative or positive – view on credit risk and transferring risk while holding the underlying asset.
Against a backdrop of this rapid growth, a reduction in the cost-prohibitive barriers to entry, and the attractions for investors of the enhanced yield potential offered from trading such derivative instruments, electronic CDS trading will gradually become entrenched and accelerate as more users are switched onto the benefits.
Initially, the CDS index products on these dealer-to-client platforms will be iTraxx Europe Main, HiVol and Crossover (European CDS indices) and CDX Investment Grade and HiVol and Crossover (US CDS indices), but could extend to single name CDS should customer demands dictate.
Critically, for a continuation of the ‘hyper-growth’ story for this relatively new asset class, it needs to rely on procedures and systems being in place to handle future growth. It’s something that has caught both the buy- and sell-side, throughout the front, middle and back offices by surprise.
Prior to an OTC trade being executed, a documentation process has to be initiated to establish a derivatives trading relationship. For fund managers, this has to be undertaken for each sub-account on behalf of which they trade. Although the recent introduction of the standard Master Confirmation Agreement (MCA) has assisted in standardising contract terms, document processing has been a fairly labour intensive pursuit since each agreement has to go through credit, legal and compliance review before trading starts.
When it finally comes to trading and once a dealer’s quote is selected, a CDS market value calculator (as in the case of TradeWeb CDS) performs a valuation of the upfront settlement fee for the contract – covering the contract spread valuation and the accrued element. Industry practice has been to settle on the spread and calculate the upfront fee at a later stage of the trading day.
Biggest causes of failure
Two of the biggest causes for trade failure are getting the legal name wrong when the trade is executed as well as the reference obligation - typically a bond (or other deliverable) that has to be referenced in a CDS trade.
To help avoid the wrong CDS entity being traded by participants, both TradeWeb and MarketAxess have integrated into their system Markit Partners’ Project ‘RED’ identifiers, the market standard that confirms reference entities and their reference obligations.
Unique nine-digit alpha-numeric CLIPS (mandatory for dealers matching on DTCC since 30/06/05) identify a reference entity/obligation pairs. This has enhanced trading and trade processing, making it easier to analyse, trade, and settle CDS contracts. Markit’s RED CLIPS are also used by the DTCC, and both TradeWeb CDS and MarketAxess have direct link’s to DTCC’s Deriv/SERV for real-time trade matching. TradeWeb CDS also validates existing trade states with Deriv/SERV records before novations (transferring one side of an existing trade to a third party) are entered into – thereby minimising trading errors and further downstream documentation backlogs.
With novations on CDS trades to third partys estimated to account for 35 per cent to 40 per cent of all CDS trades (new trades and unwinds making up the remainder), functionality in the shape of a tool like TradeWeb’s SWAPtracker facilitates execution of these novations and unwinds. The original counterparty is notified immediately of the trade so that a novation confirmation can be generated at the point of trade execution, as opposed to during the post-trade processing period. It also allows easy compliance with ISDA’s 2005 Novation Protocol.
Position management tools within SWAPtracker enable traders, middle- and back-office personnel to view open CDS positions at the block or sub-account level all on one screen and to click on any position to launch a trade ticket for a partial or full novation/unwind trade that is pre-populated with all of the pertinent information to get the trade electronically executed and processed. Other tools, as with TradeXpress make for electronic allocations on sub-accounts, while efficient management of and ready access to derivatives counterparty and counterparty information can be performed using TradeWeb’s AccountNet.
While it may be a slow burn for market participants to adjust to the technologies behind the new B2C CDS platforms and to decide whether it fits in with their requirements, momentum should build into 2006. And, with processing of CDS trade tickets set to fall 70 per cent by 2008, e-trading the CDS indices via this medium cannot be ignored. But as history shows, liquidity will be the key component of any trading system’s success and the customers’ prime concern.
Article sponsored by Thomson TradeWeb.
