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Swooning Credit Volumes Point To Leaner Times

A gradual improvement in corporate credit quality and the subsequent fall in volatility have lead to a sharp drop in credit derivatives volumes, according to a straw poll conducted by DW. This is in marked contrast to last year's British Bankers' Association survey which forecast the market would more than double by next year (DW, 9/22/02). "There are fewer hedge funds buying cheap shorts, fewer convertible arb funds hedging credit risk and the loan houses aren't hedging anymore," said Chris Francis, head of international credit research at Merrill Lynch in London.

Traders and sales professionals estimated September's trading volumes to be anywhere from 25-50% of February's figures. End users have withdrawn more than bank trading desks, noted several bankers. This is because derivatives houses are still executing delta hedges for single-tranche synthetic collateralized debt obligations, while hedgers, such as convertible bond arbitrage funds, are taking credit risk again now that things look like they are improving.

Volumes during January and February were exceptional and market professionals do not expect these to return anytime soon. The drop in volumes, however, is not necessarily permanent. "If volatility picks up volumes will follow," said Robert McAdie, head of credit strategy at Lehman Brothers in London.

Ian Linnell, head of the credit policy group at Fitch Ratings in London, said, "There are structural factors that show the market can keep growing, but it will not be the exponential growth we are used to." One of the reasons the market is contracting is because several insurers, which are traditionally the main sellers of protection, are cutting back after losses. On the flip side, there is still room for significant growth. Volumes will shoot up if smaller players join the coterie of loan houses that are active buyers of protection. On the risk taking side, loans houses will likely start selling more protection to increase their exposure to corporates. Fitch estimated that of the banks that sell protection, the average house only boosts its exposure by 5%.

Last month's International Swaps and Derivatives Association survey of credit derivatives volumes found that there had been a 25% growth in volumes during the first half of this year compared with the second half of last year. Credit professionals, however, said the reason for the increase is the huge volumes that were executed in the first couple of months of this year. ISDA estimated the market to be USD2.69 trillion whereas Fitch, which also published a survey last month, estimated it to be USD1.7 trillion.

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