Credit derivatives professionals have started to question whether credit-default swap (CDS) trading desks can remain profitable if the downturn in synthetic CDO issuance continues. A JPMorgan research report, published last week, says only two collateralized debt obligations have been issued so far this month and returns on CDOs have fallen to 20-25% from 30-40% at the end of last year. This, combined with fears about Iraq and credit quality uncertainty, has halved default swap trading volumes over the last weeks, according to traders. The current issuance of CDOs stands at about half of normal levels, according to researchers.
Many derivatives houses generate the majority of their credit derivatives profits from structured transactions, such as synthetic CDOs, according to L. Sankarasubramanian, credit derivatives researcher at ABN AMRO in New York. He added that because flow trading business only becomes profitable at high volumes many firms have focused on structured products, which increases their vulunerability to a drop in volumes.
In most credit derivatives operations, synthetic CDOs account for around 40% of credit derivatives business. Even in large firms which see most of the flow business, structured trades often account for the lion's share of revenue, said one trader.
In spite of this many credit derivatives professionals do not agree that credit desks are dependent on their structuring colleagues for their livelihood. The British Bankers Association's most recent survey of the global credit derivatives market predicts the notional outstanding volume of credit derivatives will rocket to USD4.8 billion next year from USD1.95 billion last year.
