Credit Derivatives Platform Turns to Structured Products
First published in Risk, March 2002

Derivatives brokers are leveraging their base in credit default swaps trading and jumping into the structured credit market. Why aren't dealers worried about this encroachment on high-margin structured credit business? Gallagher Polyn reports

Structured credit is no longer a game for just banks. Sunil Hirani and John McEvoy of New York's credit derivatives broker Creditex, say that since August 2000 they have done more than 24 structured deals, involving 25 to 150 credits each. The biggest deal so far has been $1 billion, and they say deal pace has been quickening in the past few months.

McEvoy and Hirani founded Creditex in April 1999 to capture a share of the booming credit default swaps market - estimated by Risk at $929 billion in total notional outstanding in November 2001 (see figure 1). Plain vanilla business is important to Creditex, but volumes are heavier at its competitors. Interdealer broker GFInet has been the top-rated credit derivatives broker by dealers in Risk's annual market survey since 1996. And against McEvoy's estimate of 8,000 to 10,000 firm credit default swap prices a month at Creditex, derivatives broker CreditTrade in London reports showing, on average, 16,500 firm prices per month.

Revenues rising

But Creditex says its revenues are taking off on the back of higher-margin structured deals. According to McEvoy, revenue at the firm had grown 6.5 times between April and November 2001, versus just three-times growth in notional traded. McEvoy says the difference is due to higher margins on structured deals. Depending on the client's transaction cost savings or the greater difficulty of finding counterparties for structured credits in the market-place, brokers of structured credit deals can negotiate higher transaction fees on structured transactions than the half or full-basis point they typically earn on credit default swaps trades. Risk estimated total global structured credit product notional outstandings as $166.9 billion in November 2001.

GFInet and CreditTrade seem to be catching on, but they are targeting different niches than Creditex in the structured credit market. GFInet, which launched its structured credit desk in May 2001, says it has so far done 12 first-to-default credit baskets, and aims to do collateralised debt obligation (CDO) repackaging and secondary marketing of CDO pieces. CreditTrade announced its structured credit products effort in January. The firm has been executing some structured transactions, but the desk will focus on baskets, portfolios and synthetic CDOs when it begins executing transactions in coming months.

Major credit derivatives dealers have supported Creditex, GFInet and Credit-Trade so far because the brokers' credit default swaps business boosts overall credit derivatives market volumes. Higher volume lowers prices, which attracts more new investors. Higher volumes also lower the trading risks of dealers by allowing them to manage their large trading books at lower cost. Some dealers with weaker distribution channels may also appreciate having the global distribution capability of the brokers at their disposal. Credit Suisse First Boston, Deutsche Bank and JP Morgan Chase are supportive enough of the market function of the brokers to have bought stakes in some of them.

A new threat

But the brokers' recent move towards structuring appears to be a threat. Sharing the John McEvoy and Sunil Hirani, Creditex: structuring teams at banks have their hands full, and their trading desks are happy to have the additional liquidity Creditex deals bring low-margin credit default swaps business is one thing. Putting together credit structures is skills-intensive, and a source of high margins, which dealers will need in order to stay profitable as margins on more standard products press down.

Though there is said to be isolated grumbling about brokers getting too ambitious, most dealers support the move by brokers into structured credit. To understand why, consider Creditex's structured credit derivatives business, which has so far been driven by buy-side interest. Hirani and McEvoy built-up extensive contacts in their 15 years' combined experience in derivatives sales at investment banks, most recently in credit derivatives at Deutsche Bank in New York.

One dealer active with Creditex specifically praised McEvoy and Hirani's strong base among monoline insurance and reinsurance companies. In this network, Hirani and McEvoy hunt for credit investors potentially interested in designing their own unfunded synthetic CDOs. Unlike in the standard CDO market, investors in deals facilitated through Creditex can choose just the names they like for their structure. Once that structure's design is complete and rated, the investor offers the portion on which they wish to sell or buy credit protection to the rest of the market through Creditex.

Executing structured transactions by phone isn't hard when a few underlying credits are involved, but adding more names adds time to the broker's task of identifying highest bidders - time dealers don't have to keep their prices still in a fast-moving market. Automating the bid/offer process online keeps transaction times to a critical 10 minutes, say Hirani and McEvoy. The execution process completes when the highest bidders are united with the protection seller to conclude the transaction by phone.

But all this is business that could have been executed by a dealer, so why don't dealers care? "They're fully maxed out," says McEvoy. Dealers confirm that their own structuring teams have their hands full, and that their trading desks are happy to have the extra liquidity brought to market on Creditex's deals. McEvoy points out that unlike dealers, Creditex takes on no risk through transactions.

Dealer interest

With greater recognition for deals brought to market on behalf of investors, dealers have begun turning to Creditex to step in to expedite their own deals. A dealer and an asset manager, neither of which Creditex would name, had been discussing a large structured credit transaction, for which the asset manager was concerned about getting competitive prices on all the ($500 million) structure's underlying securities. Faced with an impasse, the dealer suggested collecting bids on the 100 US investment-grade names through Creditex. As it happened, the original dealer ended up offering the highest bids on around half of the names, but earning the spread wasn't the big win. The win was also earning other fee income on a deal that might otherwise not have gone through. McEvoy says the asset manager got an average spread of 150 basis points on the deal - 15bp better than they were expecting. He notes that the present value of Creditex's role in the execution was worth more than $3 million to the asset manager. Afterwards, on behalf of the asset manager, Creditex facilitated the sale of the upper layer of the capital structure, with additional savings of approximately $1 million, according to McEvoy.

McEvoy says the pace of structured deals at Creditex is picking up because dealers and investors have become comfortable with the company's ability to transact and help structure complex trades. McEvoy acknowledges GFInet and CreditTrade's strong overall businesses, but says he doesn't even consider basket trades - the only structure executed by a rival broker's structured credit desk, so far - as a structured deal due to its relative simplicity.

It may be too early to tell just what impact GFInet and CreditTrade will have. John Haggerty, responsible for credit basket trading on GFInet's five-person structured credit desk in New York, says the secondary market for CDOs is weak: "I think in the course of this year there's been some reduction in CDO activity because credits have become so volatile. If we could go a month or so where a single- A name doesn't collapse, we should see some renewed buying in those markets." As for CreditTrade, Rachel Elliott, head of the firm's nascent structured credit business in London, cites the broker's strong business in credit default swaps as a key advantage, because it increases the likelihood of structured transactions getting done at lower prices. "You've got to be able to walk before you can run. And we can run very, very well," says Elliott.

McEvoy is not worried about competition from CreditTrade or GFInet in the near-term. "Having good single-names data certainly helps, but we could do this business successfully with no singlename data," he says. "It really is all about product knowledge and relationships," he adds. Traders at several dealers, many of which have invested in Creditex, back up this point. "They are by far the most sophisticated of the brokers that we talk to," said one dealer's global head of credit derivatives trading. "The reason I am not at all worried about Creditex expanding in the structured credit business is it's clearly better for our clients to have Creditex involved. We want to make sure our clients get the best execution in any deal they're looking at."

© 2002 Risk Waters Group. All rights reserved. Used by permission

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