Wednesday, December 13, 2006

Derivatives watch

A couple of interesting recent developments in the derivatives market. Here's the scoop.

Yesterday, the Financial Times reported on a new credit derivatives platform that would allow market participants to obtain prices for derivatives contracts more quickly and efficiently.

From, "New process for credit derivatives":

A new process for trading portfolios of credit derivatives via electronic auction has been tested by banks and a leading hedge fund in recent days – a development that could provide another important cog in the infrastructure for this fast-growing market.

The new system, dubbed Q-Wixx, allows investors, such as hedge funds, to execute dozens of trades in credit derivatives with different dealers in a matter of minutes rather than relying on bilateral trading deals, which tend to take several hours.

The article goes on to say that the platform could be extended to include other products in the future. A companion piece, "Q-Wixx" shrinks the world" notes that such an advancement could further the trend of derivatives products being standardized and commoditized.

Also in FT, Tony Jackson noted yesterday that a new form of "irrational exuberance" has taken over the debt and derivatives market.

To say the debt markets have gone crazy is to miss the point. I suspect the great majority of sensible investors would agree, whatever they say in public. But that does not stop them piling into super-risky assets such as payment in kind bonds (PIKs) or the new form of derivative known as the constant proportion debt obligation (CPDO).

For all I know, that may be sensible - provided the madness lasts long enough for the fleet of foot to take their profits.

The problem, as he sees it, is that the signposts of mania are far less transparent in this arena than they were in the stock market of the 1990s. See the article for more.

And finally, Bloomberg reports that exchange-traded derivatives could offer an alternative in a market currently sown up by the banks.

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. risk losing their hammerlock on the most lucrative financial market when exchanges begin offering credit derivatives next year.

Paris-based Euronext NV, which is being bought by NYSE Group Inc., plans to create contracts based on credit-default swaps, making them cheaper to trade and easier to understand than the derivatives sold by banks. Credit-default swaps, used to speculate on credit quality, also top the product list for Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt- based Eurex AG.

At stake are profits from the fastest growing financial market as exchanges list credit-default swaps alongside stocks, currencies and gold. Deutsche Bank says it earned at least $3 billion from credit derivatives in the first half of this year, about a third of total revenue from financial markets.

Hope this has helped you stay up to date on these trends.