Report confirms rapid growth of credit derivatives market

The latest British Bankers' Association survey of the credit derivatives market, published last month, confirms that the market has grown at a phenomenal pace in the past two years.

The BBA calculates the size of the market at $20.2 trillion. A particularly useful feature of the BBA survey, which is carried out every two years, is that it provides a breakdown of the market by type of participant. One finding that emerges from the report is that hedge funds have rapidly increased their share of the market.

This year they account for 28% of all trades as buyers of protection and 32% as sellers of protection - up from 16% and 15% respectively in 2004. Banks remain the biggest group of users, but have seen their share fall at the expense of hedge funds.

Bank trading books are responsible for 39% of notionals in terms of protection bought and 35% in terms of protection sold. Their loan books account for 20% of protection bought and 9% of protection sold. This is the first year the BBA has asked market participants about the split between trading and loan portfolio activities: in 2004 banks accounted for 67% of protection bought and 54% of protection sold.

Another notable finding is that index credit default swaps are now almost as popular as single-name credit default swaps. Full index trades accounted for 30.1% of volumes, up from 9% in 2004. Single-name trades fell in relative terms from 51% of outstandings in 2004 to 32.9% in 2006.The next most popular products in 2006 are synthetic CDOs (16.3%) and index tranches (7.6%).

The underlying composition of the credit derivatives market has also shifted in the past two years, with high-yield reference entities becoming much more prevalent. They accounted for 30% of outstandings in 2006 compared to 16% in 2004, according to the survey.

Michael Peterson