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The Second City Is Missing the No. 1 Growth Market
IN 19 YEARS, a child will go from the Terrible Twos to her majority. And so it has happened with financial derivatives.
Oct. 19, 1987 is a date that lives in infamy in financial history. On what came to be known as Black Monday, the Dow Jones Industrial Average shed 22% in a single session. The culprit -- or scapegoat -- was program trading involving the simultaneous purchase or sales of baskets of stocks against stock-index futures, then a relatively new instrument.
In 2006, derivatives have moved to the center of the financial world from the periphery, as evidenced by the Chicago Mercantile Exchange's acquisition of rival Chicago Board of Trade for $8 billion. The combination will create a behemoth that trades contracts worth an average of $4.2 trillion daily, dwarfing what changes hands on the New York Stock Exchange or Nasdaq.
Without a doubt, the exchanges have come a long way since the CBOT was known for trading grains and the Merc for meats. The end of fixed exchange rates and the advent of interest rate volatility were the mothers to the invention of interest-rate and currency futures in the 'Seventies. Stock-index futures took off in the 'Eighties with the bull market.
Now, these derivatives are integrated into the financial markets and economic forecasting. What's the Federal Reserve going to do about interest rates? All eyes turn to the federal-funds futures contract for the answer.
The CME-CBOT deal understandably made for some chest-thumping in the Second City. "Chicago used to be known as the hog butcher to the world. The city will now be known as the world's risk manager," boasted one CME board member to the Wall Street Journal.
But amid all the clinking of champagne glasses, the Chicago exchanges are conspicuously absent from the biggest and fastest-growing party, credit derivatives.
These instruments -- principally credit-default swaps, which provide insurance against a borrower going bust, and collateralized debt obligations, which slice and dice pools of corporate bonds into pieces appealing to different cohorts of investors -- trade over the counter. The markets are made by the giant Wall Street brokers and global banks, whose trading desks are mainly situated in New York and London. By one private estimate, the size of the credit derivatives market will reach $20 trillion -- that's trillion, with a T -- this year.
Not surprisingly, the CME enviously eyes the booming credit-derivatives business. But for at least a couple of years, the exchange is unlikely to make any significant inroads into the OTC dealer market for CDSs, CDOs and the like. That's not because of any lack of ambition but the differing nature of the contracts.
The success of the CME and CBOT has been in trading commodities, not in the sense of agricultural goods, but by the economic definition. Interest rate contracts involve the trading of money, which is as homogeneous as wheat. The same goes for S&P 500 futures.
A credit default swap essentially is an insurance policy that pays off in the event a particular borrower, usually a corporation, fails to meet its debt obligations. The premium on that policy depends on the riskiness of the borrower; just as a teenage driver pays more than his dad for auto insurance, writing a CDS against a risky borrower involves a higher premium. As a result, a CDS is more of a custom job than an off-the-rack commodity.
Buying a corporate bond means an investor is making two bets: on interest rates, as with a risk-free government bond, and also on that corporate credit. An investor who just wants to bet on that credit can write credit protection, just as an insurer writes a policy on a driver -- in the hopes of collecting a premium and not having to pay a claim.
A particular company whose credit you like may not have actually issued a bond. A CDS also is far cheaper to buy than an actual bond, just as buying an option costs a lot less than buying the underlying stock.
There also are indexes of credit default swaps, which are compiled by Dow Jones, the publisher of Barron's Online. The principal ones are the Investment Grade DJ CDX, consisting of 125 investment-grade credits, and the High Yield DJ CDX, which consists of 100 junk names. So you can bet on entire basket of high-grade or high-yield credits with one ticket.
CDOs essentially form a queue for repayment from a pool of bonds or loans. Those at the front are most likely to get paid and get the equivalent of a high-grade credit -- even from a pool of low-grade credits. At the end of the line, the risk is biggest but so is the potential payoff. In between, the pie can be carved in whatever shape desired.
Owing to their flexibility, trading in credit derivatives has eclipsed trading in actual corporate bonds. It should come as no surprise that their biggest fans are hedge funds.
Indeed, credit derivatives are transforming the corporate credit market just as the mortgage-backed securities and derivatives market has revolutionized home loans in America.
The Chicago futures exchanges, which started the revolution in financial derivatives, now are mainly spectators to the boom in credit derivatives. Why, and will that continue? Those are questions for a future column.
(c) Barrons, October 19th
IN 19 YEARS, a child will go from the Terrible Twos to her majority. And so it has happened with financial derivatives.
Oct. 19, 1987 is a date that lives in infamy in financial history. On what came to be known as Black Monday, the Dow Jones Industrial Average shed 22% in a single session. The culprit -- or scapegoat -- was program trading involving the simultaneous purchase or sales of baskets of stocks against stock-index futures, then a relatively new instrument.
In 2006, derivatives have moved to the center of the financial world from the periphery, as evidenced by the Chicago Mercantile Exchange's acquisition of rival Chicago Board of Trade for $8 billion. The combination will create a behemoth that trades contracts worth an average of $4.2 trillion daily, dwarfing what changes hands on the New York Stock Exchange or Nasdaq.
Without a doubt, the exchanges have come a long way since the CBOT was known for trading grains and the Merc for meats. The end of fixed exchange rates and the advent of interest rate volatility were the mothers to the invention of interest-rate and currency futures in the 'Seventies. Stock-index futures took off in the 'Eighties with the bull market.
Now, these derivatives are integrated into the financial markets and economic forecasting. What's the Federal Reserve going to do about interest rates? All eyes turn to the federal-funds futures contract for the answer.
The CME-CBOT deal understandably made for some chest-thumping in the Second City. "Chicago used to be known as the hog butcher to the world. The city will now be known as the world's risk manager," boasted one CME board member to the Wall Street Journal.
But amid all the clinking of champagne glasses, the Chicago exchanges are conspicuously absent from the biggest and fastest-growing party, credit derivatives.
These instruments -- principally credit-default swaps, which provide insurance against a borrower going bust, and collateralized debt obligations, which slice and dice pools of corporate bonds into pieces appealing to different cohorts of investors -- trade over the counter. The markets are made by the giant Wall Street brokers and global banks, whose trading desks are mainly situated in New York and London. By one private estimate, the size of the credit derivatives market will reach $20 trillion -- that's trillion, with a T -- this year.
Not surprisingly, the CME enviously eyes the booming credit-derivatives business. But for at least a couple of years, the exchange is unlikely to make any significant inroads into the OTC dealer market for CDSs, CDOs and the like. That's not because of any lack of ambition but the differing nature of the contracts.
The success of the CME and CBOT has been in trading commodities, not in the sense of agricultural goods, but by the economic definition. Interest rate contracts involve the trading of money, which is as homogeneous as wheat. The same goes for S&P 500 futures.
A credit default swap essentially is an insurance policy that pays off in the event a particular borrower, usually a corporation, fails to meet its debt obligations. The premium on that policy depends on the riskiness of the borrower; just as a teenage driver pays more than his dad for auto insurance, writing a CDS against a risky borrower involves a higher premium. As a result, a CDS is more of a custom job than an off-the-rack commodity.
Buying a corporate bond means an investor is making two bets: on interest rates, as with a risk-free government bond, and also on that corporate credit. An investor who just wants to bet on that credit can write credit protection, just as an insurer writes a policy on a driver -- in the hopes of collecting a premium and not having to pay a claim.
A particular company whose credit you like may not have actually issued a bond. A CDS also is far cheaper to buy than an actual bond, just as buying an option costs a lot less than buying the underlying stock.
There also are indexes of credit default swaps, which are compiled by Dow Jones, the publisher of Barron's Online. The principal ones are the Investment Grade DJ CDX, consisting of 125 investment-grade credits, and the High Yield DJ CDX, which consists of 100 junk names. So you can bet on entire basket of high-grade or high-yield credits with one ticket.
CDOs essentially form a queue for repayment from a pool of bonds or loans. Those at the front are most likely to get paid and get the equivalent of a high-grade credit -- even from a pool of low-grade credits. At the end of the line, the risk is biggest but so is the potential payoff. In between, the pie can be carved in whatever shape desired.
Owing to their flexibility, trading in credit derivatives has eclipsed trading in actual corporate bonds. It should come as no surprise that their biggest fans are hedge funds.
Indeed, credit derivatives are transforming the corporate credit market just as the mortgage-backed securities and derivatives market has revolutionized home loans in America.
The Chicago futures exchanges, which started the revolution in financial derivatives, now are mainly spectators to the boom in credit derivatives. Why, and will that continue? Those are questions for a future column.
(c) Barrons, October 19th
