Wednesday, June 5, 2013

Index credit derivatives industry is ripe for disruption

Tadas Viskanta asked the following question on Twitter today:

He is referring to a new set of ETFs that are being launched by ProShares (see story). Each ETF will mimic a long or a short position in an index corporate credit default swap (CDS). The set covers high yield and investment grade indices both in the US and Europe. The benchmark indices are CDX and iTraxx.

This ETF launch is a response (at least in part) to the mess surrounding the the implementation of the Dodd-Frank regulation, as it pertains to derivatives (discussed here). While the regulation is aimed at the dealers, it ultimately hurts end-users - particularly the smaller ones. Fund managers bring up the following concerns:

1. CDS users are forced to select a clearing bank and have to pay that bank $400-$750 per CDS trade to clear (in some cases more). Unless you are a "member" of one of the clearinghouses, having a clearing bank is a requirement. And many asset managers will try to avoid being members because of capital requirements and other complications/restrictions.

2. There are significant legal costs to put in place documents that govern the relationship with a clearing bank. These documents are in addition to the standard ISDA documentation.

3. Most end users may need at least two clearing banks. That's because in the current model, the CDS clearing business is generally not profitable for banks in spite of the high fees (it tends to be balance sheet intensive for the banks, as they have to post large amounts of collateral with the clearinghouses - see discussion). Unless the banks can scale with a specific client, there is a risk of one of them walking away, potentially shutting the client out of the CDS market. Having two relationships reduces the risk but makes it administratively messy and more expensive.

4. Not all CDS transactions will be cleared, and those that are may not be entirely fungible across the different clearinghouses. That means that end users may end up posting double the margin for fully or partially offsetting positions.

5. Becoming "clearing-ready" can also be costly, as the users need to connect to the settlement platforms and learn the new processes.

If you are a fund who trades credit or just wants to use index CDS to hedge portfolios (anything from equities to loans), you have more options now. With ETFs there is no ISDA required and no need for clearing banks. All one needs is an equity trading account and let ProShares worry about the plumbing.

Furthermore, prime brokerage accounts will give credit for risk reducing transactions, lowering margin requirements. Larger funds can set up the so-called "prime+" accounts that circumvent Reg-T by moving equity portfolios outside the US. That allows for significant leverage on ETFs and other stock positions (although one runs counterparty risk by doing so). These prime+ accounts are quite common and a large number of funds with equity or distressed credit portfolios already have them. The ProShares index ETFs will fit nicely into such accounts and allow leverage that is comparable to trading the actual CDS.

With ETFs, there is no need to "roll" positions. When you put on a 5yr CDS position, in 6 months it's a 4.5yr position and there is a new 5yr CDS trading. You want to roll out of the 4.5 year postilion into the 5-year (the on-the-run position) because the current 5yr is more liquid. Those who have done this for years know it can be a real pain, and there is a clear advantage in having ProShares do it for you. One other added advantage is that one no longer needs to rely on MarkIt (which has a monopoly in this space) or the dealers to price index CDS daily in the portfolio. ETF pricing is available on Yahoo.

Whether there is going to be enough liquidity in the product remains to be seen. If they do become sufficiently liquid, many end users on the asset management side will jump on the opportunity. Moreover, there is talk that the CME will create futures contracts to mimic these ETFs, particularly if the trading volumes are sufficiently large. The futures industry is often in direct competition with the ETF industry, and index credit derivatives is one area that's ripe for disruption.
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