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Fund Derivatives Take Off, Leaving UCITS III In Their Wake

Two new types of investors have emerged this year to take advantage of the potentially huge rewards the secondary market in structured credit products has to offer. Hedge funds and principal finance desks have been popping up in both Europe and the U.S., keen to grab a share of the huge spreads on offer. At the start of the year, traders were reporting CDOs trading 25% below their theoretical value. The CDOs were trading at such low levels because there were only a handful of players willing to make markets, according to fund managers. Spreads have come in as more funds have set up, but liquidity has also increased and this is starting to be a fruitful market.

The credit derivatives market underwent a fundamental structural change this year with the launch of two credit-default swap indices, TRAC-X, founded by JPMorgan and Morgan Stanley, and more recently iBoxx, which was brought to market by a consortium of 11 dealers. Market makers pointed to the huge liquidity boost the indices brought the market, with most dealers trading at least one of the instruments. Disputes between the rival consortia behind the indicies, however, have split trading volumes with survival of both indices unlikely over the long-term, they said.

Default swaps referencing Citizens Communications flurried in an otherwise quiet week of trading. Strong demand for five-year default protection on Citizens caused the price to jump up over 100 basis points to 162 basis points-172bps as DW went to press on Thursday from 60bps the previous week. Citizens is not usually a widely traded name, but the last week has seen it in the top two-to-three most traded credits. Traders expect the spread to widen further if the uncertainty surrounding the company's future continues.

The credit derivatives market's amazing run of growth was thrown off course this year because protection buyers, such as KBC Bank, have scaled back, resulting in volumes falling from their first quarter peaks. There are no natural alternatives to replace these players, according to Chris Francis, head of international credit research at Merrill Lynch in London. The list of protection buyers that have pulled in their horns include loan houses and convertible bond arbitrageurs. In addition, funds' hedging models were telling them to warehouse credit risk rather than buy protection, he noted.

Recent corporate scandals, including the fall of Enron, have focused attention on the role of attorneys who represent public companies. The American Bar Association Model Rules of Professional Responsibility were amended in August to permit lawyers to reveal confidential client information to prevent the client from committing a financial crime or fraud and to require a lawyer to refer violations of law by employees of the client to higher authorities within the organization.

China opened more of its financial markets to a handful of international derivatives houses this year, which in turn started to structure derivatives that allowed investors around the globe to take a punt on the world's fastest growing economy. The most significant development was deregulation of the 'A' share market to licensed foreign houses, which then offered so-called market access derivatives to give synthetic exposure without the political risk. "The market is moving in big steps," said Anita Fung, treasurer and co-head of global markets at HSBC in Hong Kong.

Robeco Alternative Investments has linked an eight-year Rabobank bond to the performance of Transtrend, a commodity trading advisor. Edwin Noomen, v.p. in Rotterdam, said "This offers investors the opportunity to invest in a CTA with a principal guarantee."

The dollar's depreciation against the euro to record lows last week has sparked a pick up in year end trading volumes in foreign exchange options. The move was sparked by exotic option market makers wanting to hedge their positions as many knock-out euro calls expire this month.

Demand for derivatives wrapped as mutual funds surged this year, but bankers are struggling to understand how instrumental a pending change in European regulations is to the sector's success. Originally bankers thought Undertaking for Collective Investments in Transferable Securities III would open up the European Union markets to funds structured with derivatives, but it appears the rules it will be more restrictive than bankers had hoped.

FirstGroup, a U.K. transport company, has entered interest rate and currency swaps on a GBP250 million (USD441 million) note to convert it into a dollar liability. "The fundamentals of the sterling bond market offered good value on relative terms to the company" said Ian Weldon, group treasurer in Aberdeen. Weldon declined to detail what FirstGroup pays and receives in the swap.

A large number of U.S. commodity desks were caught out trying to unwind short positions by the recent dramatic spike in natural gas prices, said dealers, and a hedge fund run by former Enron star trader John Arnold was rumored to be one of the biggest losers. Arnold, principal at Centaurus Energy in Houston, declined to confirm or deny the reports, noting that the firm does not comment on specific positions or its profit and loss account. "We are having a fantastic year," he said, adding that Centaurus is still the leading market maker in fixed price natural gas swaps. Indeed, rival traders said Centaurus is widely believed to have been up in excess of USD100 million prior to the rally, and therefore may still end the year with a net positive performance.