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Credit Derivative Growth Surges by 106 Percent (August 9, 2006)

Location: New York
Author: Ellen J. Silverman
Date: Wednesday, August 9, 2006

The speed at which the credit derivative market has grown has astonished many. The market grew by 106 percent in 2005 with an overall notional amount of $17.1 trillion. CDSs were the fastest-growing component of the overall OTC derivative market.

The reason for the success of the market is simple: Credit derivatives fill a natural void that existed previously in a company's ability to shift its credit risk. Additionally, they appeal to a wide range of players. Moreover, as new products are realized, new players are apt to emerge as well and changes in rankings are to be seen.

However, trading in credit derivatives has grown so quickly that it has put unusual stress on the middle and back offices to confirm and process trades effectively. The backlog reached a level last year where both the Federal Reserve and the U.K.'s Financial Service Authority commented on possible systemic risk to the financial system as a result of so many unconfirmed and unprocessed trades.

The OTC derivative market is an unregulated market, and, to that end, the Federal Reserve of New York forced 14 of the largest credit derivative dealers last fall to establish a framework for reducing the massive backlog of trades and a means to develop a structure for simplifying the processing of credit derivative trades were established. What resulted was a comprehensive framework to reduce the ballooning backlog of confirms and settlements. As part of this, there was an agreement to make use of the Depository Trust and Clearing Corp.'s over-the-counter matching service, Deriv/SERV and move toward a T+5 steady-state affirmation and matching for straight vanilla defaults and indices by October 2006. Lastly, the credit derivative dealers committed to structuring initiatives to increase the utilization of automated matching and processing. However, it became apparent that middle- and back-office technology was not in place to handle the growth in credit derivatives trading.

Pressure from the Fed and increasing market demands have brought many innovative vendors into the space to try and solve problems related to real-time affirmation and trade automation. This past year has seen a substantial interest on the part of the market to migrate to more electronic trading of credit derivative products, specifically CDSs and indices, as well as an increased drive for automation in the post-trade environment. Moreover, this year also has marked an increased use of electronic trading in the interdealer market, the introduction of index trading in the dealer-to-client space by electronic communication networks (ECNs), the introduction of e-trading of standardized products and a heightened focus on the importance of operations.

Over the next 12 to 18 months, there are several market trends that will emerge in response to the explosive growth of credit derivatives. Given the expected growth in electronic trading, there are great opportunities for technology providers. The market is young enough to offer innovators a great payoff. The industry also should expect to see the evolution of a central clearing house. The DTCC Deriv/SERV is well-positioned to become the de facto clearing house and repository of transactions in the market. Once the utility begins uploading new trades into Deriv/SERV and as it develops a framework for handling older trades already in the system, as well as the ability to process payments, the effectiveness of the DTCC in this market will become quite evident.

Since credit derivatives constantly are evolving, new product offerings, especially on asset-backed securities, such as home equity loans and credit card debt, will further increase the torrid growth in this space. The hybrid trading model also is going to have considerable success and longevity in the credit derivatives market. Although the New York Stock Exchange has made a name for its hybrid trading models, the concept has been well established in the interdealer broker market for a number of years.

As electronic markets in indices and single-name credit derivatives continue to gain traction, straight-through processing initiatives will play a vital role as well. Even though e-trading of credit derivatives is not as common in the U.S. as it is in Europe, the pressure from senior management at banks to streamline operational efficiencies will drive this effort. Many of the processes in the CDS market are labor-intensive, and moves to more-automated processes are occurring.

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