“Once we have a futures contract on the CDS index some people currently trading OTC might migrate to trading futures, but I think it is more likely that this will open up new client bases,” says David Mark, chief executive officer at IIC. “There are many asset managers with pension fund clients who do not permit them to trade CDS but would if they were listed on a recognized futures exchange.”
Untested, untried
The futures contracts will be written against IIC’s iTraxx Europe CDS Index, a static portfolio of 125 CDS on European entities that is rolled every six months. IIC chose to go with Eurex alone in order to keep things simple. “We didn’t want to split liquidity,” says Mark at IIC. “We could have held an auction process and got a number of exchanges involved. But I don’t know how many banks would be prepared to support an untested and untried product with three or four different contracts out there.”
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“I remain to be convinced that this is a retail market. How much retail business do you see in stock futures?”
David Mark, IIC |
The hope is that a CDS future will increase liquidity and the number of participants in a market. “The CDS market has reached a level where the rate of growth will probably slacken off a bit, so this is a natural development,” says a London-based CDS trader. It is seen as a logical step for CDS in the same way as it was for the FX and swaps markets. The astonishing growth in European CDS has created a lot of liquidity and it is a logical next step to go through an organized market.
But a big problem is how to achieve the correct settlement price. In a Bund future, for example, the contract is settled by physical delivery at maturity. But if you trade a CDS future you cannot enter into an index trade at maturity. You cannot enter into a contract with Eurex either – you have to have cash settlement. This could be a problem if there has been a default as the contract seller has to ensure that the buyer is compensated properly. “This is a simple problem that has a very complex solution,” notes the trader.
A complementary product
As Mark notes, the new product is unlikely to take business away from the existing OTC market but will rather increase the total investor universe. “I’m not sure how efficient this would be for hedging,” says Roger Sadewsky, investment director at Standard Life Investments in Edinburgh. “There is already plenty of flexibility out there for anyone that has looked at the CDS market as an additional tool for trading credit. I am all for encouraging wider participation and greater liquidity but it is not immediately obvious to me that people that do not have access to the OTC CDS market will necessarily pile into CDS futures,” he says. “We welcome the development of new initiatives in the credit derivatives space. The market is becoming more attractive for real money investors. Whilst the original drivers of the market – banks, hedge funds and prop desks – are still there, we do feel UK-based asset managers/insurance companies will become increasingly active.”
The likelihood that CDS futures contracts will be smaller than those in the OTC market has led to suggestions that retail investors could get involved in the new market. This is not, however, something that Mark expects to see. “I remain to be convinced that this is a retail market,” observes Mark. “How much retail business do you see in stock futures?” he asks.