Structured credit debate: Innovation grows as market matures

AB, DB It is two different things. Credit markets were significantly affected at the same time as sub-prime and equity markets were under pressure. But I don’t think there was necessarily a cause-and-effect relationship. The repricing in credit could have been mainly technical. The credit long trade was a bit overcrowded. This move was not "immatured" or exaggerated. It did not get amplified by any panic selling. We did not reach levels that would have caused any forced selling.

LF, Calyon I would argue that the credit market is fairly mature. Just look at how the market reacted to Amaranth or other recent credit events such as Dana Corp; the market did not panic and there was clearly a very orderly settlement process. Also, the liquidity is really deep, as even in volatile times there is still a bid and offer. We were in a very different situation in 1997, 1998 or 2001. At that time, banks were still the main players in the credit arena. Now, with the further disintermediation of credit markets, the global asset allocation in credit has sharply increased and we can definitely see the difference during periods of volatility.

DKK, Prudential M&G The fact that the market is moving shows that there is a degree of efficiency there. No-one wants to be the first to blink. You need some catalyst, and whether that was the ABX – which is immature – or Chinese equities, it pushed the market back to being efficient. We were previously in that stalemate position where nobody wanted to move first.

DP, Cheyne The market moves were more a case of people being positioned the same way rather than dislocations caused by lack of liquidity. In fact huge volumes can trade in a day. A market counterparty I am familiar with – a leading index market maker – trades upwards of $35 billion on a busy day. Look at the equities market. People have been positioning in a similar fashion, which is why the equities markets have rallied.

PD, Solent If the equity market goes down by 20%, everyone says: "That’s the market." If spreads widen in credit, it’s: "Oh, the market is immature." CDS have shifted trillions of dollars of credit risk from banks into other hands over the past 10 years, seamlessly. They are not given credit for this shift in the risk balance.

JI, Henderson How big an impact would LTCM have had if there had been a true credit derivative market? And what would have been the impact of Amaranth had there not been? That’s the positive change in the market. Amaranth was glossed over in a matter of days. LTCM was a different story.

LF, Calyon That is a reflection of a matured credit market. The newcomers in the credit market and those who have strongly increased their credit allocations (hedge funds, pension funds, asset managers primarily) do contribute to this liquidity.

DP, Cheyne To this point, in the tranche market, there’s much less volatility than you saw in the correlation market two years ago, because there are a lot more participants at each level of the capital structure. Imbalances of prices between different tranches become transient events, as there is now usually some kind of buyer or seller at each level to exploit the opportunity.

LF, Calyon One can even see similarities between the current sub-prime market turmoil and the adjustment in the correlation market back in 2005. Back then most dealers were positioned in the same way – being long equity risk as a result of their mezz CDO business, and when the base correlation moved down, a lot of banks were scrambling to cut the losses on their correlation books, hence creating a lot of opportunities for cheap equity or leveraged super senior. Now the market is more mature and most banks’ correlation books are more balanced along the whole capital structure. Come another correlation crisis, the market would be much more prepared than the last time. Looking at the sub-prime market, the widening and the consequential mark-to-market losses on the warehouses have pushed a lot of arranging banks to cut their losses, creating a lot of buying opportunities. Also, I believe that most banks will soon move to a model where warehousing risk needs to be actively managed and hedged, which is what we have been doing since we entered the market. It means that some banks will no longer be just ripping the carry out of the warehouse.

AL, Derivative Fitch I agree that the CDS market has become liquid and efficient, and in some respects maybe more efficient than the bond market. But indices like CDX and iTraxx have only been in existence for a few years. It’s difficult to predict how they will behave, because you don’t have enough history.

JI, Henderson There’s still not enough focus on fundamental credit in the derivative market. The focus is more on the derivative nature of the hedging instrument. The market has certainly developed and has real depth. It’s come a long way in a relatively short time.

DP, Cheyne Well, I think there are houses that are very much fundamentally driven, and use credit derivatives as the most efficient way to express that view. But I do agree a lot of trading activity in the market seems driven more by macro credit views, particularly of course using indices. As event risk in credit increases, though, the importance of fundamental analysis will become more visible.