Like all new financial markets, credit derivatives were first traded using customised, ad hoc contracts, as different counterparties came up with different ideas of how to construct trades. But over time, the conventions of the market have become more standardised.
Partly this standardisation reflects the exchange of ideas and the momentum behind successful structures. For example, the market quickly converged around the idea of trading five-year contracts as the somewhat arbitrary standard maturity (although since 2003 there has been a move away from five year contracts towards seven and 10-year trades).
But market participants have also consciously pushed for standardisation. Any firm that has traded a contract would like to see an active market develop in contracts using the same terms, so that the position can be sold in future if necessary.
For credit derivative dealers, standardisation is a double-edged sword. Greater standardisation gives new entrants to the market confidence that they will be able to find liquidity and this drives up volumes and helps ensure the permanence of the market. On the other hand, standardisation creates competition among dealers and drives down margins. Product innovation in the credit derivatives market is always affected by these two opposite forces: the need to achieve standardisation and broad acceptance at one pole and the desire to create successful proprietary structures and enhance margins at the other.
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