The business model
In late 2007 the credit crisis caused serious headaches for hedge fund traders and their investors involved in credit derivatives. Counterparty risk increased, prime brokers curbed credit lines while increasing margin requirements and secondary liquidity vanished. At the same time a growing number of defaults on investments put pressure on the infrastructure of many funds as trading staff struggled to manage documentation risk and adhere to settlement protocols. Credit derivatives rapidly became the bogeyman for many non specialists. Paradoxically, however, as these events unfolded, it also became apparent that CDS were gaining traction as a versatile hedging and price discovery tool and one which would eventually survive its adolescence and mature to take its place in a mainstream trader’s arsenal of analytical tools.
Traccr was conceptualised on the premise that many new participants in CDS trading – hedge funds, family offices, corporates, institutional investors and professional traders – would need to prepare for the coming of age of CDS. A wise risk officer would acknowledge that investing in credit risk management, price discovery and trading infrastructure could protect against the achilles heel of counterparty risk that has led to the demise of a number of hedge funds. We support and outsource CDS trading infrastructure when clients need to hedge, speculate or access customised financing.
The firm employs skilled and experienced quantitative analysts, risk managers and brokers and utilises advanced technology to assist clients which range from large, established trading operations to start-ups, enabling them to navigate and stay abreast of the constantly innovating credit markets. The technology-enabled platform offers CDS trade execution services for buy-side and price discovery on both vanilla and customised products. It provides infrastructure support for pre-trade analysis to trade execution as well as identifying solutions for post-trade processing through to clearing. Traccr can also help to reduce the cost of transacting in CDS while defining a road-map for risk management and trade settlement.
Our introducing brokerage model is helping clients execute trading strategies. We are working with a major hedge fund to execute a credit related currency swap, assisting a Fortune 200 commodities firm to hedge emerging market bank risk and helping the largest intermediary UK mortgage lender to obtain customised credit financing. The lender’s chairman commented: “Traccr has helped us identify non bank counterparties which are willing and able to execute yield trades. This allows us to continue to be a top 20 mortgage player in the UK and devise a capital markets solution to a big liquidity problem.”
Market counterparties are inclined to work with us as we bring precise orders and screen potential counterparties on their behalf. As compliance departments are loathe to trade with an unsophisticated investor, Traccr can provide an intermediary service that allows each party to become comfortable with the other. Sales people at dealers are happy to provide quotes to us as they know profitable trades can be generated and that we can help to identify clients that would hedge their axes.
We aim to provide a best practice solution for credit derivatives trading and risk management, arranging best execution on CDS with major counterparties. This can range from vanilla CDS to more exotic products including tranches on portfolios and credit-linked notes. Our experience across all facets of CDS trading enables clients to outsource the part of their process which is marginal, yet an important support, to their core competency.
With regulators demanding ever more transparency and investors requiring increasingly detailed disclosure of investment strategy and controls, the buy-side is under pressure to provide more transparency of their trading operations and communicate a clear investment strategy. At the same time the recession has arguably given rise to the greatest investment opportunities in decades, with a slew of auctions ofbusted CDOs, leverage buyouts and credit impaired businesses coming to the market. The congruence of these two events means that risk officers and chief investment officers need to weigh up the cost/benefit of investing in expert analysts or building a state of the art CDS trading operation. Most do decide to go ahead with the former and outsource the latter.
If required, we can provide human resource and infrastructure services, including the provision of on-site personnel who can pre-model trades to assess how they would fit within the investment strategy. We also offer consulting and educational services in CDS and operate a virtual CDS trading simulator to allow participants to practice trading CDS, including curve trading. This provides a realistic scenario where Markit indices and single name CDS can be traded, alongside provision of CDS news and research provided by Dow Jones. Furthermore, knowledge of protocols is important to understanding the unique features of CDS trading. For an investor to capitalise on credit trading opportunities, it is critical that they stay abreast of these developments. A good trade can easily turn sour if these protocols are ignored. Such protocols range from constituents within an index rolling, to a credit event being called to cash settlement upon default. While the International Swaps and Dealers Association has worked closely with dealers to standardise most terms, innovation in the credit markets means that trades will still be customised. In other cases, new trading scenarios, such as the first restructuring credit event under the small bang protocol of a constituent name within a Markit index (Thomson SA), in August 2009, caused a brief period of uncertainty requiring traders to think on their feet while the market determined how to settle the auction.
Adding value for hedge funds
Better Execution: hedge funds have a fiduciary responsibility to provide best execution and, in order to achieve this they must solicit quotes from at least three counterparties. However, they may not have the time to call around when a specific trade presents itself. Furthermore, dealers differ in strengths and weaknesses in terms of sales coverage, product capability and execution. Any time a trader spends calling dealers increases the risk of a trade being replicated by a prop desk or becoming less profitable as market conditions change.
Confidentiality: managers need to keep their trading strategy confidential so that their large positions do not move prices against them.
New counterparties: as credit supply has tightened following restricted lending, hedge funds need to expand their counterparty base, extending further down the spectrum of commercial and investment banks, as well as to tier 2 and 3 players. Both parties need to understand and price each other’s counterparty risk in addition to the underlying trade. Clients are interested in talking to new players and seeing what they have to offer, whether it is an investment opportunity, a credit line or general market information.
Traccr can act as an extension of a client’s trading desk. Pre-crisis there were over 15 major dealers involved in credit derivatives, with many more involved in credit related trading. While the number of major dealers has diminished, CDS trading counterparties have increased. Three client segments have emerged. The smaller, growing firms (with up to £100 million in assets) which do not have the resources to hire additional permanent employees; firms managing £100 million to £1 billion which generally prefer to invest in analysts and investment research rather than additional trading coverage and the £1 billion-plus firms which seek confidentiality of execution.
Applying trades on managed accounts
Trading financial instruments within a managed account framework allows each investor to see the individual security within their account and provides some level of control and comfort. Investment managers may decide on a particular strategyand usually employ it across all their funds, whether they are proprietary, institutional or managed accounts. They scale their infrastructure across asset classes and provide the smaller investor with commensurate execution.
Historically this has not been widely available in the CDS market where notional sizes have remained significant – rarely less than £5 million – due to high transaction costs. In the foreign exchange market, for example, upon execution of a trade, a list is submitted of each account holder to the market counterparty. The counterparty inputs the trade and matches notional amounts for each investor for sizes as small as £5,000 and sometimes less.
With growing interest in CDS, participants are now seeking notional trade denominations as small as £250,000. Traccr is working towards executing transactions of this size by aggregating trades until a sufficient size is available to hedge in the market.
Providing a brokerage platform
Our brokerage platform is supported by broking professionals familiar with CDS across a variety of asset classes, including loans, corporates, asset backed securities and emerging market sovereign credit. While dramatic improvement has been made in documentation and protocols, the vast majority of single name CDS are still customised. Customised products, termed “exotic” by some traders, include bespoke portfolios and emerging market names which are usually highly structured with bilaterally negotiated terms. The nature of these trades, and the need to maintain confidentiality, causes buy-side participants to limit conversations to parties they already know. From a cost perspective this can be inefficient and from an information perspective very limiting. Credit derivatives documentation varies widely between market counterparties and it is essential to have the expertise to understand legal clauses as they prescribe the trade and determine its liquidity in the secondary market. We ensure that clients understand the specific trade dynamics as well as pricing.
Traccr utilises a proprietary web-based order capture technology that allows customers, wherever they are located (we are a licensed broker for clients located in the European Union), to place an indicative order electronically which can then be executed quickly with a range of counterparties. E-trading is available in the CDS market but tends to be limited to the most vanilla names. Tight bid/offer levels are possible in CDS indices as well as liquid single name CDS. Documentation is standardised and as long as counterparty lines are in place, it is just a matter of agreeing price. With the advent of affirmation platforms and clearing, we believe this will herald interest in e-trading platforms incorporating price discovery, trade affirmation and straight through processing through to clearing. The Traccr platform will be evolving further to service client needs from both voice and e-trading.
Hedging counterparty risk
Credit default swaps provide a mechanism for participants in non-credit financial markets, such as commodity and trade finance. Credit spreads provide a real-time barometer to measure and assess counterparty risk and act as an accurate reference point. CDS can be used to hedge against risk to supply lines, in the absence of trade insurers which can exit the market and did so during the refinancing crisis at General Motors.
One commodities firm is using CDS to hedge their exposure to trade finance counterparties in emerging markets countries. During the credit crisis trade finance, like many other markets, was affected by the general illiquidity and lack of financing provision. Global companies that relied on trade finance to operate efficiently started to become more creative in opening up distribution channels for the exposure they were generating. CDS allowed them to broaden this distribution network because investors preferredto use CDS data over ratings to price risk. Hedge funds have also stepped into the void helping market counterparties to sell risk exposure backed by trade loans.
A senior executive in the trade and commodity structured market function at a major client says: “Traccr has provided us with relevant contacts and access to markets that we were previously unfamiliar with. Discussions are proving highly effective and we look forward to closing business shortly as a result of these introductions.” The overlap between trade and commodity finance with CDS provides investment opportunities to a wide range of players and this is a new market we are helping to develop.
Farooq Jaffrey founded Traccr in 2008 and is CEO and head broker. It is the only client-facing CDS broker licensed by the FSA. He has had senior roles in CDS brokerage at Merrill Lynch, Bankers Trust and WestLB and was instrumental in establishing structured credit brokerage and CDS electronic trading at CreditTrade.