Thursday, April 11, 2013

Credit Spread Futures and the Futurization of CDS

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday S&P Dow Jones Indices announced (PDF) the launch of three credit spread indices based upon constituents of the S&P 500.   The indices are part of a suite (PDF) of indices that "are designed to track the credit default swap market for global corporate credits, including those in distinct Global Industry Classification Standard (GICS®) sectors and sub-industries".*

S&P Dow Jones licensed the indices to the electronic exchange trueEX -- "the world's first CFTC-designated, Dodd-Frank compliant exchange" --  for the creation of futures contracts based upon the credit spread indices in the "first real adoption of [the] S&P-branded CDS indexes" according to J.R. Rieger, S&P Dow Jones Indices's VP of fixed income indexes.

Credit Default Swap (CDS) contracts are agreements between two parties that transfer credit risk from the credit protection buyer to the credit protection seller.  The credit protection buyer pays a premium (usually quarterly) to the seller and the seller compensates the buyer for losses incurred from a credit event for the debt on which the protection was bought.  Traditionally, CDS contracts have been sold in over-the-counter (OTC) markets, as opposed to public exchanges.

This development, paralleling that of the Intercontinental Exchange's licensing of Markit's CDS Indices, is part of a larger effort to move OTC instruments such as interest rate swaps and credit defaults swaps to a more transparent marketplace.  According to the Wall Street Journal, the futures contracts on the trueEX will be different from those on the Intercontinental Exchange (ICE) because "the trueEX contract will be settled based on existing auction procedures already in use in the CDS market" rather than settling "based on an index that isn't determined until the day of final settlement."

The indices mentioned in the release are:
  • S&P/ISDA US Corporate 120 Credit Spread Index is composed of reference entities whose primary corporate issuer's sector is not financial.  The top 120 eligible reference entities are included in this index.
  • S&P/ISDA US Financial 30 Credit Spread Index is composed of reference entities whose primary corporate issuer's sector is financial.  The top 30 eligible reference entities are included in this index.
  • S&P/ISDA US 150 Credit Spread Index is simply the combination of the constituents of the two indices above.  
According to the methodology, the indices are rebalanced five business days prior to the quarterly IMM dates and each series matures fives years later.  The reference entities must be rated investment grade by the majority of the three major ratings agencies that rate the reference entity (S&P, Moody's and Fitch).  In addition, the reference entities must have long-term senior public debt and CDS priced by CMA.  The indices are equal weighted with each reference entity having a notional value of $5 million.

While these futures contracts are likely still far too complex for retail investors, the move to public exchanges could decrease barriers to entry for traders to express opinions on credit risk.  According to the WSJ article, the size of the futures contracts will be significantly smaller, which would likely increase liquidity and accessibility.  In any case, like the futurization of interest rate swaps, the futurization of CDS contracts could be a major step in the movement of OTC 'exotic' derivatives to transparent and regulated exchanges.
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* For more information about GICS®, see the following from MSCI.

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