Functions and benefits

Credit derivatives have seen extraordinary growth over the past two decades. Credit default swaps (CDS), originally created in the early 1990s, were contracts that commercial banks entered into in order to transfer credit exposure in their loan portfolios to a third party. By entering into a CDS contract, banks were able to shift the risk of default to their swap transaction counterparties. With the loan default risk no longer counting against their regulatory capital requirements, the banks were able to make additional loans.

In the late 1990s, CDS contracts were being negotiated with corporate and municipal bonds as the underlying reference entities. Banks were still the primary participants in the marketplace since the contracts were not widely used outside this select group. With a limited number of participants, counterparties knew each other and understood the intricacies of this new product. For the most part, buyers of protection also owned the underlying credit. In 1999, with the advent of standard documentation for Over the Counter (OTC) derivatives trading, the International Swaps and Derivatives Association (ISDA) made it possible for new participants to enter the market.

In the early 2000s the market began to expand rapidly. Asset managers and hedge funds began to find trading opportunities in this developing marketplace. With new parties involved in the CDS market, a secondary market for both buyers and sellers of credit protection began to develop. Investors and speculators became increasingly large players in the market once dominated by the banks.

With speculation becoming rampant, profiteers were now taking credit positions without owning the underlying credit assets (loans or bonds). The CDS contract allowed market participants to take a long or short view on a particular credit and transact much more easily than in the cash corporate bond market. Since contracts are bilateral, large positions could be entered into with little or no initial payment, based on the ‘relationship’ between the transacting counterparties. According to an ISDA market survey, at the end of 2007 the outstanding notional amount for CDS contracts was well in excess of US$50 trillion.

As a market develops, institutional players invariably find ways to monitor the market and construct products that can be used by their sophisticated client base. Just like the equity and bond markets, CDS indices provide market participants with such a tool. They allow measurement of credit markets, hedging of broad market credit risk and the ability to take views on, and speculate in the direction of, the credit quality of the underlying assets represented in the CDS index.

In 2001, J.P. Morgan and Morgan Stanley were the first to create indices for this relatively new asset class. In 2003 the banks merged the indices under the Trac-X name. Separately, iBoxx launched a series of CDS indices. In 2004 Trac-X and iBoxx merged, creating CDX indices in North America and iTraxx indices in Europe and Asia. These index families provide a broad-based measurement of the credit markets, with the best known indices capturing more than 100 reference entities in each market.

In 2009, S&P Indices developed its first CDS indices, launching with a family of three. Today, the S&P/ISDA 100 CDS index is still the only index based on the constituents and weighting scheme of one of the most frequently traded equity indices. With the combination of equity, futures, options and CDS, many investment strategies can be created across the capital structure in order to capture perceived mispricing in a variety of markets.

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