Credit derivatives volumes continue to explode but dealers have convinced regulators that the market is no longer a ticking time-bomb in terms of processing problems.
The effectively default-free backdrop to credit trading in 2006 has brought its own problems, however. Industry representatives at the recent IFR credit derivatives roundtable pinned their hopes for a significant broadening in the market on the development of a liquid loan-based credit default swap market.
This market has suffered from the documentation wrangles that accompany development of any new derivative contract. It has also been held back by the reluctance of bank loan portfolio hedgers to trade the new instrument. An environment of extremely tight spreads might seem like a good time to buy cheap credit hedges. But default swap premiums – though very low – look like a large portion of the total spread available on a loan at the moment. And many bank loan portfolio hedgers are still struggling to justify their activity internally, given that their banks are being forced to report significant mark to market losses on hedges of loans that are accounted for on an accrual basis.
The market for credit options is also proving slow to develop liquidity, and some participants at the roundtable had significant concerns about potential problems in the asset backed security credit default swap sector.
While there have not been any significant defaults in 2006, many companies have reformed their capital structures, with at times significant effects on the value of related credit derivatives.
The possibility that bank trading operations could have knowledge of corporate finance decisions, such as successor entity choices, that will affect the value of default swaps has opened another area of concern over possible insider trading.
LBO activity remains the main focus of fears that information is being used by insiders to profit via credit derivatives trading, though participants at the roundtable did not view this as a significant issue. The dealers in attendance pointed out that banks and brokers are already subject to significant regulation, while highlighting the lack of standard practice for hedge funds that become privy to buyout information.
The technical factors that affect the relation of bond and default swap values are generally understood in principle, though they can surprise even experienced market professionals in practice. The roundtable discussed recent shifts in bond to swap basis levels and the development of a viable market for curve trading of credit derivatives. If spreads remain low, some participants expected a market for 15-year default swaps and synthetic CDOs to develop next year.
There could also be an increase in the number of Triple A rated credit derivatives product companies in the market next year, and credit futures could finally launch.
Roundtable participants were not holding their breath for either development.
Nor did they want to second guess the timing of an eventual turn in the extraordinarily benign credit cycle. The roundtable participants hoped for an increase in spreads and volatility in 2007, though of course you should always be careful what you wish for.
