An article in Wednesday’s Financial Times, Unbound, by Gillian Tett, discusses how trading in credit derivatives generally and in the iTraxx contract in particular has become more important than the bond markets.
Because my brain is a bit fried due to jet lag, I will be brief and hopefully won’t oversimplify, although I will probably sound like a Luddite.
Derivatives are highly useful but potentially dangerous tools. The foolhardy can blow themselves up much faster with them than they would by simply buying securities.
The article gives ample indication that credit derivatives are being used naively, without full appreciation of their risks. Very few people have the math skills to have an intuitive feel for how derivatives work. Yet the article reports that there has been explosive growth in trading volumes, and that fixed income managers feel compelled to use derivatives (as opposed to investing only in securities) because they will fail to show competitive results otherwise. These instruments are increasingly being used to play points of view, an activity that can most charitably be described as speculation.
If this sort of thing were occurring on a small scale among savvy players, it would be healthy. But in these volumes, it’s anything but. Large amounts of capital are being channeled to uses far removed from the financing of the economy. At some point, these derivative trades become self-referential rather than derivative. Suck enough trading volume out of the cash market and the cash prices become increasingly dubious reference points for the formation of derivative prices. And derivatives often fail to perform as expected, particularly in difficult markets, making their value as a signal or a hedge least useful when most needed.
From the Financial Times:
When Matt King, an analyst at Citi, started covering credit derivatives a few years ago, his clients tended to be investors with a specialist interest in the credit world.
This month, however, he is witnessing a striking change: many requests he receives about areas such as the oddly-named iTraxx index – a specialised European derivatives basket that can be traded as a contract – now come from across the markets spectrum. Traders in the yen-dollar market, for example, are now so hungry for information on iTraxx that they have asked Mr King for direct data feeds.
“I spend half my time rushing down to the equity team or talking to foreign exchange people,” he says with a chuckle. “Where we used to follow equities, suddenly all anyone cares about is what is happening to iTraxx.”
It is a comment being echoed around the markets this month, as market turmoil has driven an explosion of trading in these once-obscure derivatives contracts – some with names that might be taken from science fiction. Indeed, activity has been so intense that it has sometimes rivalled that in the better-known equity world. “Volumes and volatility have been unprecedented,” says Sunil Hirani, who runs a credit trading platform in New York and London.
These indices are becoming so important that they are starting to affect seemingly unconnected asset classes – such as the yen. The derivatives “tail” to the corporate credit market, in other words, is now wagging the dog in a manner never seen before. “These credit derivatives indices are [now] the mainstays of the financial markets,” says Tim Frost, co-founder of Cairn Capital, a London-based investment fund, who suggests that without the lubrication of these products, “the engine of the credit markets would have seized up weeks ago and be belching acrid smoke”. Or as Mr King notes: “Whereas previous crises focused on govies [government bonds] or the S&P500 future, suddenly the iTraxx Crossover is the world’s hedge instrument of choice.”
By any standards, this marks a striking development, not just for the bond market but asset managers generally. What is perhaps most remarkable is that indices such as the iTraxx did not even exist five years ago. Indeed, the concept of “credit derivatives” is itself relatively recent.
The term was coined in the mid-1990s, when banks such as JPMorgan and Bankers Trust created derivatives contracts known as credit default swaps (CDS), which allowed investors to place bets on whether a corporate bond would default. (Typically, one party to a CDS promises to compensate another party if a bond defaults in exchange for an annual fee, expressed as a spread.)
Initially, CDS were a specialised category of finance, primarily used by bankers to manage their own lending risk. Indeed, as recently as six years ago, so few CDS contracts existed that when data were published on derivatives trends, CDS did not merit a separate categoryand were lumped into the “miscellaneous” derivatives bucket.
However, this decade the sector has exploded dramatically (see chart below left), to the point where the CDS market is now 10 times larger than the tangible cash bonds on which they are supposed to be based. That is largely because investors have stumbled on a crucial point: not only do CDS contracts insure against default, but trading these derivatives can act as a substitute for trading corporate bonds.
More specifically, if investors like a company, they can express that positive view by selling a CDS contract to someone else (thus betting that there is little chance of default). That has a similar economic effect for an investor as purchasing a bond, even though no new finance is raised for the company itself. Conversely, if investors dislike a company, they can buy protection against default – thus effectively making the same bet as if they had sold a bond.
Indeed, for many investors trading CDS contracts is more attractive than dealing with tangible corporate bonds. One reason is that the CDS sector is far less fragmented than the corporate bond world, since each company typically has one main CDS contract attached to its name (even though it may have issued numerous cash bonds).
Another key attraction is flexibility. The size of the corporate bond market is limited by companies’ need for funding, which in practice has been much less than the desire of investors to trade credit. The derivatives market does not face the same restrictions. If investors want to trade more contracts, bankers can simply create them by pressing a few computer keys (always assuming that a buyer and seller can agree on price, limited only by investors’ appetite for risk). CDS thus offer bankers a 21st-century cyber-heaven: a virtual financial world that can be conjured up by traders rather than tangible companies themselves.
Unsurprisingly, bankers have responded to this freedom by creating numerous products out of CDS. However, the single most important development – and the one that has turbo-charged the sector this summer – is the emergence of the CDS indices, run by IIC, a small Frankfurt-based data company. These indices, going under the family names of iTraxx in Europe and CDX in the US, began their journey towards dominance of the credit markets only three years ago after a group of investment banks buried their differences and merged competing products.
They are now traded by investors as instruments in their own right and used to create entirely new products. The fact that the indices are large baskets of different companies’ debt also means that investors who know little about the real analysis and tricks of investing in credit can make simple bets about where they think the market in general is going.
This summer, those investors have rushed to take a more defensive stance on credit, partly due to the worsening news from the US mortgage markets. In previous cycles, the only way they could have done this would have been to sell bonds or other debt assets. However, during times of stress this avenue is often closed because of a shortage of buyers. As one investment fund recently wrote in its weekly letter: “Cash credit markets have virtually ceased to function.”
Consequently, asset managers increasingly turn to the arena where they can still trade – the iTraxx and CDX indices. And this has triggered a self-reinforcing cycle: precisely because investors now think credit derivatives are more liquid, they are becoming more wary of cash instruments, which is pushing even more activity into derivatives. Thus it is the price of credit derivatives indices – not bonds – which moves first in response to economic news or shifts in investor sentiment. So when investors in other sectors such as equities want to track the credit markets, the first place they look is the iTraxx or CDX.
“The whole point of a market is to let participants trade with each other and transfer risk,” says Mr Hirani. “This is what credit derivatives have let investors do at a time when many other markets have been substantially challenged.”
This, in turn, is starting to transform the wider asset management world. When credit derivatives first appeared, they left some mainstream asset managers uneasy. The esoteric structure of instruments such as iTraxx jarred with the investment approach of many old-style corporate bond investors. However, traditional bond fund managers are discovering that it is almost impossible to perform well against their peers unless they follow the herd by using derivatives. As a senior fund manager from Pimco recently noted: “If you are compared to a benchmark [as a credit fund], it is hard to not use derivatives now.”
Not everybody welcomes this shift. Some company executives, for example, hate the idea that investors are now focusing so much attention on an instrument that companies themselves never created at all. “It scares me,” confessed one British corporate treasurer at a recent investment seminar in London, who likened the derivatives arena to the “Second Life” virtual world on the internet, because it is almost completely detached from the real corporate world.
Other observers worry about the longer-term implications of so much activity rushing away from exchanges into a market that is private and lightly regulated. In the past couple of years the investment banking community has scrambled to improve the infrastructure of the CDS sector: trading systems have improved under heavy criticism from regulators, and a procedure has been -developed for settling CDS contracts when companies do default.
However, these efforts have not removed all the potential logistical hiccups: some investors worry, for example, that the system for settling CDS when companies default is untested in Europe. Meanwhile, because trading activity occurs away from public exchanges, the sector is less visible to regulators than many other spheres.
It is difficult to judge the magnitude of the recent wild swings in the indices against what is a short history for the product, and even more difficult to work out exactly what is driving the moves.
For example, the indices covering relatively safe investment-grade bonds have counter-intuitively performed much worse than the riskier junk-rated indices. Many analysts and bankers believe this is to do with the hedging activities of huge programmes of complex investment products run by the big banks. However, analysts cannot even tell what volume of trading has occurred, since – unlike listed equity markets – there is no central source of data.
The question of who is making these trades and why is even more difficult to fathom. Thus much of the movement in the indices may be governed more by so-called “technical” factors than real changes in investors’ appetite for credit risk.
However, problems like this are unlikely to deter investors right now: barring any serious infrastructure problem, most bankers are confident that the sector will keep expanding next year. The market is changing in focus too, as increased attention is given to indices of derivatives of private equity loans and bonds backed by mortgages. Indeed, an index related to the US subprime mortgage market became one of the strongest early signals that a broader credit storm was gathering as hedge funds and others increasingly bet on troubles in that market.
For the moment, in other words, there seems to be little chance of the genie of virtual finance going back into the bottle. Citi’s Mr King and and his peers look set for a very busy summer.