Eurex held its first meeting with derivatives dealers last week in London to hash out the specifications for a credit derivatives futures contract. The meeting included market makers from the rival indices, iBoxx and TRAC-X, but attendees said the meeting was focused on the mechanics of a contract rather than choosing an index. The banks behind the two indices are racing to get U.S. and European exchanges to launch futures referenced to their indicies, in the expectation that this will turn credit derivatives into a mainstream financial instrument. Uwe Velten , spokesman at Eurex, declined comment.
The main sticking point at last week's meeting was whether the future should be cash or physically settled at maturity. Attendees voted five-to-four in favor of physical settlement, with BNP Paribas abstaining. ABN AMRO , Deutsche Bank , Citigroup , Dresdner Kleinwort Wasserstein and SG CIB voted in favor of physical settlement . Officials said JPMorgan , a co-founder of the TRAC-X indices, led the charge for cash settlement.
Traders agree that the cash settlement mechanism, in which the owner of the future pays or receives the difference between the value of the future and the current index price at mutrity, is the simplest method of settling contracts. The problem, however, is that because of the credit derivatives market's relatively small size, the price could be manipulated around the settlement of large positions. For example, if a dealer executed USD3 billion (notional) of contracts it could spend around USD100 million at the maturity of the contracts to make the fixing tighter and get out of the USD3 billion of contracts at a more advantageous rate.
The proponents of cash settlement, however, argue that the expense and risk of managing collateral positions will harm the liquidity of the contract. The physically settled contract has to use credit-linked notes rather than a default-swap because many of institutions that use futures are not allowed to enter over-the-counter derivatives. The notes would use Pfandbriefe as collateral, which means there is an added credit risk and also a market risk of the prices of Pfandbriefe moving against the index.
