Selling Credit Protection On 2,100 Names
Spreads are becoming wafer-thin in the burgeoning credit derivatives market. At the same time, two Internet-based credit derivatives electronic communication networks have started up in recent months. So why on earth would a group of bona fide derivatives luminaries decide to open up a credit derivatives boutique focusing on the already-liquid market for big-name credits?
Because, for starters, their new venture, ePrimus, is approaching things from an entirely different perspective. Instead of serving as a credit derivatives broker or intermediary, the firm intends to act as a creator and investor, selling credit protection in the form of default swaps on the universe of more than 1,500 investment-grade names through a unique structure.
"The germ of the idea was to create a derivative products company that would be an investor in credit risk,” explains Joseph Bauman, CEO of ePrimus and former managing director and head of derivatives sales and structuring at Bank of America. Bauman is working with three other heavyweights: Tom Jasper, former global treasurer of Salomon Smith Barney and co-founder of the International Swaps and Derivatives Association; Gregg Whittaker, former global head of credit derivatives at Chase Securities; and Alec Rainsby, former head of Merrill Lynch's debt markets technology group.
ePrimus is the brainchild of The Shidler Group, a New York-based private investment firm that incubates and nurtures businesses. (It's created 34 companies to date—mostly in the financial, insurance and real estate markets.) Two years ago, the company saw an opportunity in the credit derivatives business that hadn't been exploited by anyone to that point: becoming a manufacturer of credit derivatives rather than a dealer. Playing a role in the creation of financial products, and building the market's liquidity and capacity, presented enormous profit opportunities.
Jay Shidler, the firm's chairman, and Rob Denton, managing partner of Shidler and one of the firm's directors, began laying the groundwork for the company in 1997. Their first order of business: securing a triple-A rating from ratings agencies. There was no blueprint for the kind of financial marketplace Shidler was trying to create, so the triple-A rating was critical both in building a management team and in marketing the firm's products. Finally, in October 1999, after spending close to a year working with the agencies, ePrimus received its first triple-A intent to rate letter from Standard & Poor's. Jasper and Whittaker joined at that time and Bauman and Rainsby soon followed.
The early dealings with the rating agencies were tricky, of course. The agencies had been rating structured vehicles that involve special-purpose companies investing in credit risk—in the form of collateralized loan obligations and collateralized debt obligations—for a long time. But whereas those assets are essentially static, ePrimus was proposing a dynamic portfolio to be constantly updated and refreshed. The capital models would have to be created from scratch. Moreover, whereas the products of other triple-A-rated derivatives subsidiaries are assessed in terms of pure counterparty risk—the risk of the issuing party defaulting—ePrimus' products primarily reflect the risk of the underlying assets.
Fashioning models that account for all of these exigencies wasn't easy—but ePrimus thinks it's done the trick. "Our models relate to how a very diversified portfolio of risk will perform over time based on historical loss equivalents that the rating agencies have put together,” says Bauman. "It starts with the loss matrices that the agencies have created and that others such as KMV have refined and fine-tuned. But we've spent a fair amount of time and money with a variety of experts in the field to fine-tune those models to better capture the dynamic of the products we will manufacture. The static models themselves would not properly capture the portfolio dynamics we expect to have in a diversified pool.”
The hard work seems to have paid off. "We've worked with the ratings agencies to come up with a structure that makes sense to them and that they're willing to rate at the highest level possible,” says Jasper. "We expect to receive triple-A ratings from Moody's, S&P and Fitch.” The company plans to begin trading its products in October.
While ePrimus goes to great lengths to point out that its business model doesn't threaten credit derivatives dealers, the company believes it's got some clear advantages over the dealer model. Unlike dealers, the firm is not dependent on the ever-narrowing bid-asked spread. "As the end investor in these instruments,” says Bauman, "we're not looking to make money off the bid-offer spread. We view ourselves as employing proper diligence in modeling and judging risk to earn money over time. We're in the business to capture a fair return on the credit risk we're assuming through the sale of credit swaps.”
Another advantage, says Jasper: as an investor in these products, ePrimus' investment horizon is quite broad, covering the entire 2,100-name investment-grade universe. Contrast that with dealers that, in the course of developing banking relationships and carrying out original market research, grow comfortable with maybe 100 or 200 credits. "Dealers tend to focus on those sectors that they understand the best,” says Jasper. "Typically those names are the names that the institution either has a close relationship with, or that they have some clear understanding of the credit, either though a strong research department, which is normally the case, or their lending relationships.”
ePrimus' other big advantage: technology. Pricing will be delivered on-line through its web site, www.eprimus.com, as well as via Bloomberg and Reuters. Trades will be executed on-line, and will be fully linked to the relevant ISDA-type standardized documentation. "It will be essentially a straight-through process,” says Bauman, "from the point of our counterparty showing an interest in buying protection on a specific name, to the closing and documentation of that trade.”
The company's technology will also make ePrimus the low-cost provider in this market. The tech-heavy firm plans to hire no more than 20 to 25 people, "of which there'll be small trading staff, a small marketing staff, a risk control team and the necessary support staff,” says Jasper. "We expect most of the dirty work to be done by the technology.
ePrimus expects to receive its AAA/Aaa credit ratings and to become operational in the fourth quarter of this year. Later, it plans to expand its product offerings into the credit insurance and letters of credit markets.
The company is already setting its goals high. "Our expectation is that we'll be doing several billion dollars in notional value in our first year,” says Bauman. "And we'd naturally want to keep growing beyond there.”
But won't this novel new approach alienate credit derivatives dealers? Hardly, says Jasper. "We want to be very close to and friendly with the dealer community. We don't view ourselves as a competitor to dealers—our desire is to have a reasonable market share in a large and growing market. And to the extent that the market continues to grow, we should do that.”
Trading Interdealer OTC Derivatives, Quietly
Visitors who go to blackbird.net hoping to get details about the company will find themselves facing a digital brick wall. The site contains a few sketchy descriptions of the system and some job postings, but nothing that would give prospective users a feel for the world's first Internet-based over-the-counter derivatives trading system.
Yes, the first. While most competing systems are months if not years away, Blackbird has been quietly trading U.S. and Canadian dollar interest rate swaps and forward rate agreements since last November. "Blackbird is named after the famous spy plane, built in secrecy, ahead of its time and under budget,” says CEO Shawn Dorsch. "We thought those were good ideals to shoot for.”
The company says it has signed up 35 financial institutions that operate in the United States, a number that includes banks headquartered in Canada, Britain, Germany, Switzerland and Japan. It has also recently received approval from the U.K.'s Securities and Futures Authority to trade sterling, euros, Swiss francs and Japanese yen products from London. Blackbird says it has signed up another 25 other institutions there and will soon be open from the beginning of the trading day in London to the close of business in New York.
Thus far, however, the company has not released any volume figures. "I will simply say that there are large number of orders in the system every day, that we do transactions every day, and that volume has been growing steadily,” says Dorsch.
The project was originally conceived by Raymond May, an early member of JP Morgan's derivatives group. In 1996, he was joined by Shawn Dorsch, who had served as an equity derivatives trader at JP Morgan before joining First Union in 1993 as its first swap trader.
The two raised initial funding from friends and family and hired TIBCO to build the system's order-routing and messaging infrastructure while the company's internal programmers built the derivatives-specific functionality.
May and Dorsch say they chose to headquarter in Charlotte, N.C., because of the city's lower cost structure, its strong political support for banking and its proximity to the technology companies based in nearby Raleigh.
Last year, the company received a major investment by the Internet Capital Group, which paid about $29 million for a stake in the company. The firm now has about 60 employees and has opened an office in London that will enable it to offer a full range of services to its clients in Europe. The firm has rented office space in Tokyo, and hopes to begin trading there this fall.
Hit the bid
On a typical day, traders logging into the site will see several dozen live bids and offers in the system. Trading in interest rate swaps is offered both as a spread over Treasury bonds and as an absolute rate. Counterparties are anonymous to each other until the trade is completed, but the deals that appear on a trader's screen are color-coded, based on what his bank permits him to trade and his bank's credit standing with the other banks on the system.
Green means you have permission to trade with that counterparty for that particular transaction. Yellow means the counterparty will not take your credit for that transaction. Red means that your financial institution has turned down the potential counterparties' credit for the transaction.
Traders eager to do a particular deal for which they do not have credit, however, can activate a private chat process with the potential counterparty, reveal their corporate identities and try to work out credit enhancement terms on the fly. Usually, this involves changing the size, maturity or pricing of the transaction, or the details on mutual puts. "We definitely have a lot of yellow trading,” says Dorsch. "People will be surprised by the amount of credit enhancement that goes on. And lot of people use mutual puts, which is probably a good thing.”
Traders who have hit a bid for a particular amount, say $25 million, and want to do more can ask in a private chat if the counterparty would be willing to do more at the same price. In some cases, if the poster of a bid or offer permits, traders can also take pieces of larger deals in $25 million increments. In the near future, traders will also be able to trade with specific banks without revealing their trades to the multitude.
After a transaction is complete, counterparties receive a simultaneous acknowledgment with trade details electronically. Back-office personnel can pull up all of the transactions from their own screens and print out trade details several times if desired. All transactions done in the system are bilateral OTC swaps transactions, and fall under ISDA master agreements just as in telephone-based trading. Counterparties, however, still need to get signed paper confirms from each other.
The actual trading system is a Java application that installs on an individual client and is accessed via the Internet or private network connection. Connections with users are constantly monitored. If a user goes off-line, bids and offers are automatically canceled. Blackbird also has a staff of activity monitors, composed of former derivatives traders, marketers and technical staff, who watch users trade and ensure that the process operates in a smooth and proper manner. Blackbird's activity-monitoring staff also has access to real-time data from Reuters and CNBC, in addition to system statistics, in order to be able to respond to any sudden changes in activity.
|"I sold my house for this. Ray did the same. We believe. we have religion.”
Dorsch says one of the most successful and innovative parts of the system is its FRA switch facility, which allows banks to manage cash flows associated with swap books better. The system allows a firm to upload all cash flows for the next 90 days and then locate banks that naturally need the opposite positions in order to hedge themselves. The firm has developed a system for swap switches and plans to adapt the technology to other instruments as well.
Blackbird says it plans to expands its product line into interest rate options, caps and swaptions, as well as a broad range of currency derivatives. "We are doing the most complex part of the business with the most barriers to entry,” says Dorsch. "It is much easier for us to expand into simpler products than it is for other people to modify their systems to do more complex stuff.”
Dorsch insists that the firm has no plans to expand its user base beyond the dealer community. It might, however, be willing to partner with others to expand into other areas. The firm has applied for numerous patents, with more than 200 associated claims.
One of the most immediate plans is for improvements in straight-through processing. Currently, once a deal is done, either via a voice broker or electronically through Blackbird, dealers must retype deals into their back-office systems. Now that the system has been in use for several months, some user banks are beginning to request links to their back-office system.
Dorsch doesn't think he will put competing voice brokers out of business. "When people want to do a five-year swap trade, they'll put a bid in Blackbird and call their broker and will work them simultaneously,” he says. "Over time our share will continue to grow.” Although he realizes other electronic systems with different business models and mandates will emerge as competitors, he argues that only two or three will become dominant players.
Blackbird says it does not immediately expect the sort of exponential growth associated with retail electronic stock trading. Even when traders are eager to get on the system, it takes six to eight weeks to set up new users and work out the internal corporate, firewall and network issues. After traders are set up, it takes more time for them to feel comfortable enough to jump in and actually use the system. "People will watch for a while before they actually do something, but the longer somebody has it, the more they do,” says Dorsch. "The first guys that installed this thing back in September are some of our biggest and most active users.”
Dorsch is equally eager to separate itself from the hype associated with other Internet startups. "People think you can start something and within a month have 30 percent or 40 percent of the business,” he says. "They are foolish for even imagining something like that. These things take time, because it is about changing the way that people do things.”
"We are unbelievably tenaciously committed,” he concludes. "I sold my house for this. Ray did the same. We have our lives in this thing. We believe. We have religion. Even though we have a huge war chest, we are cognizant that tough times can come along—so we are in it for the long haul.”
A New Platform for OTC Derivatives
The over-the-counter equity derivatives markets have never been a model of efficiency. Pricing requests and negotiations are handled by phone and fax, and every deal is treated like the china doll it isn't. And this, despite the increasing homogenization of equity swaps, forwards and zero-cost collars.
Now, a new platform designed to use the Internet to enhance the structuring process for standard OTC equity derivatives—such as volatility and variance swaps, options, swaps and collars—intends to change that.
StructuredMarkets Inc., an on-line customer-to-dealer platform (www.structuredmarkets.com) plans to automate the key areas of the structuring process that are manual and inefficient. If this works, dealers as well as end users could benefit in spades. The idea: since the majority of OTC equity derivatives are competitive, rather than one-off, products, the process should be commoditized as much as possible. OTC equity derivatives will never be a flow business, but as the market continues to expand, so does the need for relatively uncomplicated products such as zero-cost collars.
StructuredMarkets' grand plan to tame the OTC equity derivatives market has three components: the distribution of product information, standardization in the pricing process, and a more efficient documentation process.
One challenge marketers have always faced is getting information about new products out to those who might be interested in using them. StructuredMarkets would therefore build a customizable Yellow Pages of equity derivatives end-users—and is now developing a list of buy-side clients. The goal, says Dean Curnutt, who founded the company with former colleagues from Lehman Brothers and an additional partner, is to create a community with approximately 10 broker-dealers on one side of the table, providing information about their products, and potentially hundreds of end-users on the buy-side in five or so investor areas: corporates, hedge funds, insurance companies, institutional money managers and asset managers, and regional broker-dealers. "A broker-dealer isn't likely to send a hedge fund information on FASB 133, for instance, but a corporate might care a great deal,” he points out. The ability to tailor products according to investor classification would be a marketing boon for sell-side clients.
The second element of the StructuredMarkets plan involves pricing. An auction mechanism wouldn't make sense, says Curnutt, because that requires strict fungibility of contracts, which isn't the case with OTC equity derivatives. Instead, the company will opt for a request-for-pricing engine to streamline inquiries and the delivery of pricing. A buy-side client, for instance, would choose the dealers it wants pricing from, describe the transaction and send the electronic "term sheets” to the dealers. The dealer would see the client come in—it would see, for example, that XYX hedge fund wanted pricing on a one-year equity swap—and would price the transaction, and then use the system to submit the pricing to the client. The client could then make an apples-to-apples comparisons of dealers' competing quotes. The platform would also provide pricing analytics for end-users and dealers.
The third leg of the StructuredMarkets stool involves documentation. The firm's hope is to automate back-office functions such as confirm-generation, and enable clients to securely exchange documents and data on-line. "We envision an on-line filing cabinet,” says Curnutt. "An end-user may have documentation set up with five dealers, and could click on a specific dealer to see master agreements, confirmations, mark-to-market collateral statements, reset notices—all of which are sent to him securely through the site.” The confirmations generated would integrate into dealers' middle offices and ultimately into the end-user's system as well. Structured-Markets hasn't yet committed to a specific technology to do this.
The firm received initial seed money from Boston-based Usheron Venture Partners; another round of funding will close shortly. The platform charges dealers a transaction-based fee based on the product type and the notional value of the contract negotiated on the system. Structured-Markets also plans to generate revenue through site subscription fees payable by end-users interested in the pricing engine and the site's research, content and documentation features.
This month, the firm says, a beta-test of the system will launch with roughly five dealers and 10–15 buy-side users. Curnutt adds that some 100 buy-side institutions have registered on the system and are currently looking at the site's functionality (users have not yet been asked to commit to using the platform). StructuredMarkets expects the site to roll out at the end of the summer, eventually expanding along geographic, rather than product, lines—to Europe and later to Japan.
If all works as planned, the StructuredMarkets site could well make the OTC equity derivatives market a whole lot cozier.
By Nina Mehta