JP Morgan brings complex derivatives to wider audience

IFR 2289 22 June to 28 June 2019
6 min read
Christopher Whittall

JP Morgan has stepped up efforts to get more clients trading credit derivatives, including synthetic CDOs, through a platform that makes it easier for investors to take leveraged bets on corporate debt markets.

The US bank launched its Credit Nexus platform earlier this year, according to a person familiar with the matter. The platform is designed to simplify the cumbersome process investors usually face to trade derivatives, including credit-default swaps, CDS options and synthetic collateralised debt obligations, according to a client presentation obtained by IFR.

Rather than taking direct exposure to such instruments, users of the platform can instead buy certificates packaging together a range of credit derivatives as well as corporate bonds, FX forwards and interest-rate swaps. The presentation highlights how the certificates enable clients to lever up their investments several times over, while lessening much of the operational and market risks typically associated with trading derivatives.

“It’s a huge effort to negotiate ISDAs,” said one credit investor, referring to the International Swaps and Derivatives Association’s standard legal document governing derivatives trades. By contrast, the investor called JP Morgan’s platform “ISDA-lite”.

JP Morgan’s 22-page client presentation, which says it is for “professional and eligible” investors only and not retail, notes there are a number of “operational hurdles” to trade derivatives. Those include, the presentation says, having legal documentation in place as well as booking and monitoring the risk of trades.

Derivatives users must also comply with rules regulators introduced following the financial crisis to reduce risk in the US$544trn over-the-counter market, such as reporting trades and funnelling them through clearing houses.

The presentation says JP Morgan’s platform is “designed to streamline these requirements” by effectively removing them for clients, as certificates do not need to be cleared or reported.

SURGING VOLUMES

The move to allow more investors to get exposure to complex derivatives comes amid surging volumes in many of these products in recent months. That growth has coincided with a sharp drop in government bond yields across the world, narrowing the pool of high-yielding investments on offer for fund managers.

IFR reported in April that trading volumes in synthetic CDOs linked to credit indexes were up 40% this year after topping US$200bn in 2018. Trading in options on CDS indexes now stands at US$20bn–$25bn a day, analysts say, which is higher than trading of US high-grade corporate bonds.

Banks including Citigroup and Goldman Sachs have been looking to take advantage of growing client interest in these products. That includes the controversial, crisis-era synthetic CDO, which has been revamped to focus solely on whether corporate defaults will rise.

JP Morgan’s Credit Nexus platform allows investors to get exposure to synthetic CDOs linked to credit indexes. The bank’s client presentation suggests such investments are suitable for asset managers, hedge funds, insurance companies and pension funds to use as “hedging overlays” among other things.

LEVERING UP

JP Morgan devotes several pages of its presentation to highlight and explain one of the main advantages of getting exposure to derivatives through the platform: leverage.

Unlike when buying a bond, investors do not have to stump up all the cash needed to match the full size of their positions when trading a derivative. Instead, they only need to post a fraction of that total amount in margin. In this way, investors can make bigger bets on credit markets than they could ordinarily, leading to potentially outsized gains – or losses.

“This [certificate] is designed to replicate the economics of trading derivatives in an OTC format,” the presentation says. “Investors do not need to post [US$100m] of cash to trade [US$100m] of CDS.”

JP Morgan uses a measure called the “total scenario loss”, calculated based on the risk of a portfolio using various market shocks, to determine the amount of leverage that can be used. There are also maximum caps on leverage for different trades.

The presentation gives an example of an investor using a €10m certificate to buy default protection on €50m of iTraxx Crossover, the European high-yield index, in effect levering their position five times. JP Morgan says the “TSL” on this trade comes to €4.5m, leaving a €5.5m buffer on the certificate against market moves.

The investor does not need to do anything so long as the value of the certificate exceeds that TSL of €4.5m. But if the market shifts so that the certificate is now worth just €4m, the investor would have to make a decision. Either hand over more cash, de-risk the portfolio by reducing the size of the position, or do nothing, leading to the certificate being terminated.

That differs from trading OTC derivatives directly, when the bank and investor would exchange margin every day to cover any mark-to-market moves.

JP Morgan charges running costs for its platform, which are higher for riskier products. There are also higher fees if the client chooses to use banks other than JP Morgan to execute the trades underlying the certificate. Running costs are lower if the client chooses a type of derivative called a total return swap rather than a certificate to place its trades.