The global credit markets will most likely look back on 2005 as a landmark year, and not just because it witnessed the beginning of the end of the Greenspan era, or because of the headlines chronicling the passing of some venerable investment grade names into the high-yield market.
The more enduring milestone has been the virtual redefinition of the structure of the credit markets by the acceleration in the growth in the credit default swaps (CDS) market. It is clear that a broadening range of credit market participants have been turning to the CDS market, in addition to the cash market, to implement their investment strategies.
Hedge funds, and, to a lesser extent, real money accounts, are finding in the CDS market a level of customisation, sophistication and liquidity that they require to manage their credit portfolios. As a result, today the true price of credit is heavily influenced by the flows in CDS. And despite several instances of market dislocation, driven by the auto sector in April and May and more recently with Delphi, the CDS market has held up very well and has functioned as intended during turbulent times.
Electronic value
This development has, in turn, underscored the value of an electronic transaction platform that gives access to both the cash and CDS markets. Indeed, events in 2005 suggest that the ability to move the most common types of CDS onto an electronic trading platform will be fundamental to ensuring continued development of the global credit markets.
The growth in CDS, and the corresponding regulatory scrutiny that the industry has attracted as a consequence of the resulting backlog of confirmations, has thus become another factor driving further adoption of electronic trading of credit products.
A quick comparison of the US high-grade and CDS markets illustrates the growing importance of the CDS market relative to the cash market. NASD TRACE data indicates that the average daily volume in the U.S. high-grade market is currently running at approximately $8bn, reflecting a year-over-year decline of over 20 per cent.
By comparison, the CDS market grew by nearly half in the last six months, rising to $12,400bn in notional outstanding in the first half of 2005 from the $8400bn in the second half of 2004. Estimates by the International Swaps and Derivatives Association (ISDA) now put the CDS market at some $14,000bn in notional amount with average daily volume in CDS indices in the client to multi-dealer space running between $20bn-$30bn.
Increasing backlogs
Considering the burst of activity in the CDS market, it is not surprising that regulators began to worry about backlogs in the CDS settlement process and other growing pains in this fast-developing marketplace. This acceleration of industry growth had in fact outstripped the back-office resources of most of the primary CDS dealing houses and hedge funds. So much so, that there was a clear call for the re-engineering of the settlement process coming after the recent Federal Reserve Bank of New York meeting in September and a prior letter from the FSA in February.
It was immediately clear that electronic, institutional investor client to multi-dealer credit trading platforms, such as the MarketAxess system – the first platform to be launched in the space – had an important role to play in addressing these problems. The expertise we have as the leading global electronic cash credit trading platform in the institutional client to multi-dealer space provided us with important insights into how our technology could be applied to the operational issues in the CDS market. Well before the regulators went public with their concerns, MarketAxess had been working on ways to bring similar efficiencies to the CDS market.
Our platform was built to provide an alternative and more efficient channel for investor clients to send order flow to dealers participating on the platform. Over the past few years, electronic trading has grown to a far greater extent than originally envisioned by the dealer community, and institutional investors now find it much easier to display their orders to a group of dealers through electronic trading channels versus the traditional telephone process.
The success of MarketAxess is a textbook case of how the efficiencies achieved by electronic trading spur on market participants to greater levels of adoption. Our bond-trading platform now includes 25 leading broker-dealers and more than 600 active institutional investor clients. Though high-grade corporate bond trading volumes in the cash market are off by 20 per cent in the last year due to difficult bond market conditions, MarketAxess’ high-grade trading volume as a percentage of the NASD’s TRACE data increased to 7.6 per cent for the first nine months of 2005, up from 5.8 per cent during the same nine-month period in 2004.
Trading efficiencies
The same electronic trading efficiencies, which have served to bolster best execution in the cash markets, are now the basis for eliminating the serious confirmation backlog problem in the trading of credit default swaps. Just as we have sought to provide all participants in the cash markets with the best available prices in the market by providing the highest quality and quantity of dealers competing for business, we are also working diligently with the market to develop electronic solutions that will reduce outstanding confirmations and provide electronic confirmation and matching that achieves T+0 confirmation for all trades going forward.
We are achieving T+0 confirmations by working with industry leaders such as the Depository Trust and Clearing Corporation’s (DTCC) Deriv/SERV subsidiary to ensure that dealers and clients on our platform have Deriv/SERV accounts open, which will facilitate the matching and confirmation process. Furthermore, we are working with Markit Group to integrate their industry leading Reference Entity Database (RED) service to remove the possibility of uncertainty over contract terms which had historically led to breaks throughout the trade process. Lastly, we have incorporated all the requirements of the recent ISDA novation protocol into our electronic trading process to make the assignment and unwind trade process efficient and robust.
What’s next for the CDS market? While we cannot expect the CDS market to sustain its torrid growth of the last few quarters, expansion will likely continue at a significantly high rate. Hedge funds will remain major drivers of activity in this market, but more traditional market participants will continue to gain confidence and expertise in these instruments.
Electronic platforms such as MarketAxess have created the tools for the industry and now the industry must step to the plate and begin leveraging these capabilities. Collective efforts on behalf of the industry to date are encouraging, and we look forward to working with market participants to resolve these important issues.
Richard M. McVey, chairman and chief executive officer of MarketAxess Holdings.
