Banks turn to CDS after electronic platforms flop

Reuters - UK Focus

By Danielle Robinson

NEW YORK (Frankfurt: HX6.F - news) , Feb 24 (IFR) - Wall Street banks, having failed tomake any money out of electronic bond-trading platforms, are nowfocusing on ways to benefit from new regulations enforcing thecentral clearing of credit default swaps.

A Greenwich Associates survey released last week revealedthat only 1% of investment-grade corporate bond investors usedsingle-dealer platforms, such as Goldman Sachs (NYSE: GS-PB - news) 's GSessions, lastyear.

Nevertheless, banks such as Citigroup (NYSE: C - news) and Barclays (LSE: BARC.L - news) are stillkeen to discover ways to offset derivatives and trading profitslost due to stricter regulations, and are hoping there will be ajump in single-name CDS use once the SEC rules later this yearthat they need to be centrally cleared.

"We think that moving CDS credit clearing to a centralcounterparty gives rise to a more specific use of CDS as arating enhancement tool," said Peter Aherne, head of NorthAmerican capital markets, syndicate and new products atCitigroup.

The use of single-name CDS has dropped by about a thirdsince the crisis, according to Morgan Stanley (Berlin: DWD.BE - news) , to around US$1trnoutstanding in net notional terms. Banks and other users havefound it less useful to hedge against credit risk in anenvironment of record low default rates.

But Morgan Stanley's Sivan Mahadevan, head of US creditstrategy, believes CDS use will actually increase because of theVolcker Rule.

"Thanks to the Volcker Rule, market-making and generalrisk-mitigating activities in banks may motivate additional useof CDS," he said.

Barclays has become the first committed market-maker onMarketAxess's central limit order book electronic tradingplatform for single-name CDS.

"We are hopeful that these market structure changes lead toincreased liquidity in the product," said Bob Douglass, head ofcredit electronic trading at Barclays.


Citigroup, meanwhile, has developed a bond product witheBond Advisors that aims to capitalize on the significantdecline in counterparty risk once single-name CDS is centrallycleared.

The product involves an issuer putting language into thedocuments of a new bond issue that will allow those securitiesto become enhanceable by attaching CDS protection after launch.The end result is a single-CUSIP instrument that has thepotential for an improved rating.

"The real value created by the eBond enhancement is thecreation of a 'single' instrument for trading, rating, financingand accounting," said Richard MacWilliams, managing partner ateBond Advisors.

The eBonds can be enhanced as much or as little as theinvestor wants, can be traded as a single entity, or can besplit into the two separate pieces. On a Triple B instrument,for example, 50% enhancement would imply a Single A rating, 80%Double A and 100% Triple A.

Among the potential users are bank treasury departments,currently swimming in excess liquidity and investing mostly inTreasuries and MBS.

Banks have been increasingly turning up in high-quality bondissues at the short end of the curve to boost investment returnsin a low interest rate environment.

The eBond tool could conceivably enable them to purchaselower-rated bonds and enhance them up to the point where theyare only exposed to rate risk, but still provide a higher yieldthan a government security.

The biggest potential users are investors who do not dabblein CDS or are restricted from buying lower-rated bonds.

"If you can figure out a way to package the insurance intothe actual bond that just turns it into one security, then whatyou are doing is opening up the entire world of corporate bondinvestors to the use of a product that requires single-nameCDS," said Dexter Senft, co-head of fixed income electronictrading at Morgan Stanley.


Investors and sellside competitors are generally curious andwill be interested if the tool turns out to be economicallyefficient and liquid.

"We potentially would be interested in buying enhanced bondsbecause they offer the opportunity to adjust the risk in namesthat might otherwise fall out of our acceptable risk profile,"said Richard Donick, chief investment officer at DCI.

Citigroup now has to find an issuer willing to embed theeBond language in bond documents. The argument that this couldexpand a borrower's investor reach is a hard sell, however, in amarket in which US$7bn-plus book sizes are common.

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