Some 20 credit traders from the major firms, including UBS, Deutsche Bank, Goldman Sachs and JPMorgan, are aiming to standardize recovery swaps in an attempt to boost volumes. Dealers want a standard instrument to increase liquidity so they can more easily hedge recovery rate risk that has built up in their single-tranche collateralized debt obligation books, explained Alex Reyfman, a managing director and head of credit derivatives research at Bear Stearns in New York. He said bankers trade every permutation of credit risk except recovery, adding, "It's time we trade this one as well." A recovery swap is an instrument through which investors can take or hedge exposures to recovery rates in the event of a default.
The traders, who gathered for the first time late last month to hammer out the issues, hope to focus attention around a single instrument within six months, according to Ian Clague, a managing director for North America at GFI in New York, who is leading the initiative. He said a standard product could boost recovery trade volumes to about 5% of the credit default swap market over the next couple years. Currently, few recovery swaps are traded, he noted.
Clague said the two instruments in the running for the standard are zero-strike digitals and fixed-for-floating recovery swaps. The zero-strike digital is a credit-default swap with a zero recovery rate, meaning if there is a default the buyer of protection receives the full notional value of the contract, Reyfman explained. This contract pays an explicit premium to the seller over traditional default swaps. Clague has seen investor trades in zero-strike digitals on General Motors Acceptance Corporation and Ford Motor Credit.
The dealer community favors zero-strike digitals because they are clean and easier from a documentation standpoint, said one credit trader.
