Credit derivatives' volumes exceed $ 45 trillion: ISDA survey

The half-yearly credit derivatives data released by ISDA says that credit derivatives volumes, as of end June, 2007, have gone beyond $ 45 trillion, at about $ 45.46 trillion. This scales a growth of 32% from the $ 34 trillion data as of end 2006, and nearly 75% growth over the half year of 2006.

Credit derivatives have been growing at an annual rate of nearly 100% over the past 3-4 years.

During the tremendous credit squeeze that started in the wake of the subprime crisis, credit derivatives volumes are likely to be affected this year. There are several reasons for this - hedge funds who became primary players in credit derivatives in 2004 onwards are likely to stage a retreat, or at least slow their activity this year. CDO activity is completely moribund post July 2007. In general, the market has become risk averse.

Increased role of hedge funds has increased risk of correlated movements in credit markets: Fitch

Rating agency Fitch recently came up with a special report on the role of hedge funds in the credit markt [Hedge Funds: The Credit Market's New Paradigm, report dated 5 June 2007]. The report states something that anyone having an insight into the credit derivatives market might surely know, but what might look shocking to an outsider. The credit derivatives market is not where banks meet to swap each other's credit risks. It is fast becoming an arena for risk-takers and betters who take leveraged positions on credit risks. Hedge funds occupy nearly 60% of this market today.

Apart from the sheer volume of trade, "(T)he impact of hedge funds on the credit markets can not be measured simply by trading volumes, but also must consider hedge funds’ willingness to be risk takers by investing lower in the capital structure. By investing in instruments that are themselves levered, hedge funds are able to create a multiplier effect by
combining financial leverage with so-called economic leverage. The combination of the two can be thought of as the effective leverage", says Fitch.

There is ample evidence that hedge funds, in search for high returns, take subordinated positions in pools of credit. That apart, they are major players in equity tranches of the indices.

What does this highly leveraged position of hedge funds imply for the credit market? The downgrades for GM and Ford in May 2005 brought sharp MTM losses for several players because of the highly correlated moves by several hedge funds trying to unwind their positions due to their mandates or deleverage triggers. Fitch says that a similar result is almost inevitable. "Credit assets could behave in a more correlated, synchronous fashion if one or a number of hedge funds were forced to liquidate positions following some catalyst event in the markets. Investor redemptions and/or increased margin calls from prime broker banks could exacerbate a larger unwind of credit assets". Hedge funds are far more unstable investors than buy and hold investors of relationship banks.

Besides, hedge funds are typically short-term strategy based. Many of them have short horizons within which they either perform or must wind up. While hedge funds have continued to improve their risk management abilities, there is no way they can eliminate risks, and the next downturn in business cycle may really bring forth this critical situation.