Credit derivatives: S&P to launch CDS indices


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Can the index provider’s expertise in equity markets translate into fixed income?

Standard & Poor’s intention to launch its own family of credit default swap indices has been met with some scepticism from the market about the likely success of the new product.

The announcement comes just weeks after Markit Group, which is owned by a consortium of 16 banks, snapped up CDS IndexCo and the International Index Company, thus consolidating most of the best-known and widely used CDS index products in one company and, ultimately, under one brand name.

"It will be very hard to get people to trade [the S&P indices], especially given volumes in which the current contracts already trade," says a London-based credit derivatives banker. "They might try to get this to trade on exchange. The exchanges are looking for indices to trade, maybe not in Europe but in the US."

S&P will introduce three US-focused CDS indices in the first quarter. There will be the S&P US Investment Grade CDS index, the S&P US High Yield CDS index and the S&P 100 CDS index. The indices will be offered in two forms: one that will incorporate all credit events that have occurred and another that will remove defaulted credits when a credit event occurs.

"S&P obviously is a brand name that has a tremendous franchise already on the equity side of the [index] business," says Craig Feldman, director at S&P in New York. "The credit default swap market and the credit markets have been at the forefront of people’s attention now for a few years. We will leverage a lot of our expertise on the equity side into the fixed-income side. Getting into the CDS market is a natural progression for us as we expand into the fixed-income arena."

Feldman admits that there will be client overlap with Markit but believes S&P’s CDS products will differentiate themselves and offer an alternative to the established products. For example, the S&P 100 CDS index, which will include 80 to 90 of the most liquid names in the S&P 100 equity index, could give investors the ability to make capital structure plays – debt versus equity – by trading the two indices against one another. S&P will also market its CDS indices to its established equity index manager client base some of which have the ability to trade fixed income.

"I think the S&P CDS 100 index is where, based on the feedback we’ve gotten, people are excited and see the product as interesting and a bit different," says Feldman. "But ultimately the market will determine how it is going to play our indices."

There should also be the opportunity to launch secondary products off the new CDS indices, says Feldman. The version of the indices that incorporates credit events was structured with secondary products such as exchange-traded funds (ETFs) in mind. The incorporation of defaults effectively eliminates the vacillation in price that occurs in the established indices when a credit is, effectively, in default and experiences spread widening until it drops out of the index. The elimination of this could be better for structuring an ETF. However, CDS index-based ETFs are not new. Several have already been set up using the existing indices, with both Deutsche Bank and JPMorgan in the market with products.

Apart from the significant competition that Markit’s range of CDS indices provides, S&P might find itself with problems of another kind. The index provider will use CMA DataVision as its primary source for pricing. Feldman points to working with CMA as a benefit because of its ability to provide independent data. However, some credit derivatives bankers cast doubt on the data’s quality. Some claim that CMA’s data is based on a messaging frequency rather than how credit actually trades, which makes it impossible to judge how much risk is being traded.

On top of that, some banks are in dispute with CMA over data sourcing. "There are certainly some very interesting letters being sent in both directions between a number of the market participants and CMA," says a credit derivatives banker. "The reason is because CMA basically gets their data from dealer runs that are forwarded to them without the dealers’ permission." This is a continuing dispute, the resolution of which could affect S&P’s CDS index plans.