Credit crisis helps CDS market to keep on growing

By Jane Baird

LONDON, Oct 8 (Reuters) - The $50 trillion market for credit default swaps is set to continue a five-year trend of breakneck growth and increasing sophistication after serving a vital role during the summer credit crisis.

Investors turned to CDS -- mostly using market indexes -- in July and August to hedge risk, taking advantage of CDS liquidity as spreads widened and they lost confidence in other more complex credit products.

"This was the first correction in the credit markets when investors could use credit default swap indexes to hedge themselves," said Marcus Schueler, head of credit product marketing at Deutsche Bank.

"Without CDS indexes, there would not have been any transparency about where credit is priced."

The growth in CDS is providing investors with new ways to trade credit, while supporting the underlying bond and loan markets for corporate borrowers.

"There is no question that CDS afford investors the opportunity to adjust or tailor market exposure in a way that previously would have been impossible," said James Batterman, a senior director at Fitch Ratings.

"But it remains to be seen how the CDS market in its current size would respond to something approaching the 2001-2002 period, when there were massive defaults across the board," he said. "That would be the true test."

For now, the market is likely to mushroom this year after more than doubling in four of the past five years. In the first six months of 2007, it grew 75 percent year-on-year to reach $45.5 trillion in outstanding contracts by end-June, according to the International Swaps and Derivatives Association.

BOOSTING CASH BONDS

GFI, a leading CDS inter-dealer broker, has seen demand recently for its electronic screens from a few traders in other markets, such as interest rate options and even foreign exchange options, who want to keep an eye on CDS indexes as indicators.

"Before it was the Dow, the FTSE, the long bond. Now they also want to know where the Crossover is trading," Swain said. "It is being accepted as part of the mainstream today."

Many macro hedge funds ventured into the market for the first time in the summer to take advantage of its volatility.

A number of insurers such as Aviva (AV.L) are starting to shift portfolios from bonds toward credit default swaps, said Barry Hadingham, senior manager of derivatives compliance for Morley Fund Management, the UK insurer's in-house asset manager.

"It's an issue of liquidity. The CDS market is a lot more liquid than the underlying bond market," he said.