Intercontinental Credit-Swap Futures Said to Shield Default Risk

Credit swap index futures planned by Intercontinental Exchange Inc. are being designed to shield investors from the risk of underlying borrowers defaulting, according to two people with direct knowledge of the matter.

The contracts, which may begin trading in April, will reference upcoming Markit Group Ltd. indexes that contain only companies that are current on their debt payments, said the people, who asked not to be named because details aren’t public. Investors in existing swap indexes are affected if members default because the composition of the basket changes.

Intercontinental is seeking to capitalize on providing broader access to directional bets on credit markets by obtaining in October the right to link futures to indexes owned by Markit, the largest creator of the derivative instruments in the $23.8 trillion market. The license, which no other exchange has, may give the contracts a better chance of success than previous efforts to offer credit swap futures.

In 2007, the world’s largest banks that buy and sell credit-default swaps resisted efforts by CME Group Inc. and Eurex AG to offer credit swaps-like futures. That was before the September 2008 failure of Lehman Brothers Holdings Inc., one of the biggest swaps dealers.

Then in 2010, Deutsche Bank AG, Goldman Sachs Group Inc. and Morgan Stanley held discussions with exchanges including CME Group about creating futures contracts on credit swaps indexes, people familiar with the matter said at the time.

Markit CDX

Previously, Atlanta-based Intercontinental said the contracts would begin trading in the first quarter and didn’t specify which exact Markit indexes would be referenced.

The first four contracts from Intercontinental, which last month agreed to buy NYSE Euronext for cash and stock worth about $8.6 billion, will be based on the Markit CDX North American Investment Grade Index, the Markit CDX North American High Yield Index, the Markit iTraxx Europe Index and the Markit iTraxx Crossover Index, the people said.

“We are in the final stages of a process to work out the details of these products with market participants,” Brookly McLaughlin, a spokeswoman, said in an e-mailed statement. “As soon as this is final, we will make an announcement.” She declined to comment on the details of the contracts.

Because there’s no default risk associated with the futures contract, the margin investors have to pay will be low, according to the people.

Low Margins

The Dodd-Frank Act, passed in 2010 to overhaul financial-market regulation, is moving most credit swaps into clearinghouses. The contracts will also trade on electronic systems after the unregulated transactions contributed to and complicated efforts to resolve the credit crisis.

Futures, which are agreements to buy or sell an asset or commodity at a specific price and time, on credit swaps may open the investments to small hedge funds and others who can’t afford to participate or don’t want to take the risk of transacting in the swaps market.

Benchmark credit-default swap indexes are created every six months. The old index is replaced in a process known as a roll that allows companies to be removed if they no longer have appropriate credit grades, aren’t among the most actively traded borrowers or fail to meet other criteria. Any companies that defaulted are also replaced.

In September, the new series 19 of the Markit CDX North American Investment Grade Index added Ford Motor Co., MeadWestvaco Corp. and Staples Inc., replacing CA Inc., GATX Corp. and a unit of Vornado Realty Trust.

Intercontinental, which owns the world’s largest clearinghouse for credit-default swaps, plans to offer futures that mimic the performance of the swap indexes later this year, the people said. Those contracts will reference the basket of companies and face the effects of any defaults, the people said.

The idea behind the first contracts is to offer investors a new product, rather than one that mirrors an existing index, they said.

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