THE MAIN PRODUCTS

Unlike Isda's survey, the BIS figures give a breakdown of the market by type of instrument. At the end of 2005, just under 73% of outstandings were for single-name contracts, with multi-name instruments (that is, baskets, index tranches and synthetic CDOs) accounting for the remainder.

As this survey shows, synthetic CDOs are only a small part of the market in terms of volumes, but they are a big force driving the growth of the market. Dealers issue these investment vehicles to investors including banks, pension funds, insurers and individuals, and then hedge themselves by trading other credit derivatives such as single name credit default swaps, credit indices and index tranches, so increasing the amount of activity in all credit derivatives.

Cashflow CDOs are not usually thought of as credit derivatives, but they are certainly structured credit products. And they play a similar role to synthetic CDOs of channelling investments into the broad credit market.

According to figures compiled by Creditflux, there was a total of $469 billion of cashflow CDOs outstanding at the end of 2005, with $194 billion of new deals issued in 2005 alone.

WHO IS INVOLVED?

The credit derivatives business has historically been dominated by banks and investment banks. This is not surprising when you consider the major roles that banks and investment banks play in the credit business. Commercial banks are the main type of institution involved in lending money to companies using loans. Meanwhile, investment banks (also known as securities houses) underwrite and distribute the bonds which governments, financial institutions and corporates (non-financial companies) issue to the broader investment community.

Banks - There is a common perception that banks use credit derivatives mainly to reduce their exposure to credits they do not like. While this may be true for many banks, it is by no means the whole story.

All banks are regulated indirectly by the BIS (under regulations called the Basel Accord, and to be updated in the future to the Basel II Accord) to reserve a certain amount of capital against the assets they hold. This is called the bank's regulatory capital requirement and it depends on factors such as the credit risk and maturity of the assets it holds. Regulatory capital is a measure designed to preserve bank capital, since the riskier a bank's assets the more capital it has to reserve against those assets.

The credit portfolio management function of a typical commercial bank looks at the profitability of the assets on its balance sheet, taking into account the regulatory cost of holding those assets. The credit portfolio manager may choose to sell an asset that does not provide enough of a return over its regulatory capital charge or does not fit with its portfolio strategy. Alternatively, in many cases, the credit portfolio manager will hedge the risk using a credit derivative, which allows the bank to release regulatory capital.

In addition, banks of all types make use of credit derivatives as an investment tool. Many banks have a proprietary trading desk which makes short or medium-term bets on credit in much the same way that a hedge fund does. In addition, many commercial banks invest in single name credit or in synthetic CDO tranches on a longer term basis. They may also be a dealer (see below). Many regional banks act as a dealer within a certain niche, for example, repackaging synthetic CDOs for smaller banks and investors in their own country.

Dealers (market makers) - Dealers or market makers provide a service allowing market participants such as banks, insurance companies, corporates and hedge funds to buy and sell credit derivatives, making money from the difference between the buying and selling price (known as the bid and the offer). They can be commercial banks such as Citigroup or investment banks such as Morgan Stanley.

Large credit derivative dealers typically offer a wide range of credit derivative instruments and make a market on a broad choice of reference entities. In almost all cases they also trade credit derivatives for their own book, though sometimes this proprietary trading business is kept at arms length from the market-making function. Most credit derivative dealers have dealing desks in New York and London, and some also trade from Hong Kong, Singapore, Sydney or Tokyo.

The biggest credit derivative dealers have historically been JP Morgan and Deutsche Bank, two large universal banks (offering both commercial banking and investment banking). In recent years, the business has become less concentrated and around a dozen firms can be thought of as full blown credit derivative dealers. The list of institutions signed up as dealers on the main credit derivative indices in Europe and in North America (see table on page 13) gives an indication of which banks are involved as credit derivative dealers in each region.

Hedge funds - Hedge funds, investment management vehicles designed to produce positive returns regardless of the direction of the market, are typically short-term investors. One of their biggest concerns is to ensure that they will be able to get out of - or unwind - a position when they need to. (This ability is known as ‘liquidity'.)

For a long time, few hedge funds traded credit derivatives, regarding the market as too illiquid for their purposes. That changed in around 2003, with the launch of the liquid credit derivative indices that later evolved into iTraxx and CDX (see page 30). This meant that for the first time, hedge funds could trade in and out of credit in large sizes without losing large amounts of money on the difference between the buying and selling price (the bid-offer spread) on each trade.

Since then, hedge funds have become key players in the credit derivatives market. Anecdotal evidence suggests their share of the market in terms of outstanding trades has grown substantially since 2003, when the BBA survey put this figure at 15%. In fact, because they are active buyers and sellers, hedge funds can often dominate daily trading volumes.

Some of the biggest multi-strategy hedge funds such as Amaranth, Citadel Investment, Moore Capital and Tudor Investment are active in the credit market. Other big hedge fund players are credit specialists, typically set up by former credit derivative traders at investment banks. These include BlueMountain Capital, Cairn Capital, Cheyne Capital Management, Solent Capital and Tricadia Capital. Most credit hedge fund managers are based in London or in various locations in the United States. The funds themselves are usually domiciled offshore.

Asset managers - Asset managers that manage institutional money are fairly active in credit derivatives, especially those that manage CDOs. Traditional long-only funds such as mutual funds are much less involved. However, their involvement is thought to be increasing, and many funds have become members of the DTCC DerivServ settlement system for credit default swaps (see page 75) in 2005 and 2006.

Insurance companies - Insurance companies are involved in credit derivatives in two different ways. Life insurers and property and casualty insurers hold large investment portfolios to match their liabilities. Some have invested a small portion of these funds into credit derivatives, generally using credit-linked notes.

The other way insurance companies use the credit derivatives market is by writing insurance policies. In economic terms, this is similar to selling protection on credit default swaps and these insurance policies are usually converted into credit derivative contracts through a special insurance vehicle known as a transformer. The insurance companies that are involved in this business include both specialist bond insurers known as monoline insurers and reinsurers.

Pension funds - Pension funds are not big players in the credit derivatives market, though some funds have invested in CDOs and their involvement is growing. Pension funds often face compliance issues in trading credit derivatives, since their investment management guidelines often prevent the use of derivatives.

Retail investors - Credit derivatives are wholesale financial products that can almost never be traded directly by individual investors. Not only are the minimum trade sizes too large for most investors, banks are usually prohibited from offering these products to retail customers.

However funded credit derivative products such as CDOs and credit CPPI products, which more easily lend themselves to being highly rated or principal protected, are an exception. These products are commonly sold to high-net-worth individuals, and in certain countries (notably Australia, Canada and the Netherlands) have been sold to true retail customers.

Corporates - Despite the best efforts of many credit derivative salespeople, big corporates have not taken to using credit derivatives in the same way that they routinely hedge their currency or commodity price exposures.

Interdealer brokers - Interdealer brokers do not trade credit derivatives themselves. They act as agents when credit derivative dealers trade with each other. As in other derivative markets, almost all credit derivative trades between dealers are brokered by one of the small number of these specialist firms. The biggest include Creditex, Creditrade, Garban, GFI and Tullett Prebon.