Credit Default Swaps, Part Two: ICE and Other Exchanges

My favorite investment in the CDS market to be is the Intercontinental Exchange (ICE). Founded in the year 2000 in Atlanta, the ICE pioneered the market for WTI Crude [West Texas Intermediate Crude]. Most of this commodity is from smaller wells in Texas and Oklahoma. Plus, the ICE recently has benefited from the surge in sugar and coffee prices [and hence traders were buying/selling these contracts to hedge their volatile positions]. Anyway, the ICE has benefited from providing liquidity in the commodity market - and their purchase of the NYBOT was accretive to earnings from an early stage [from the get-go in fact]. Some analysts have recently downgraded the ICE and reduced earnings estimates by a little.

But, more significantly, in the SEC filing by the ICE:

On June 3, 2008, the Company entered into a definitive merger agreement to acquire Creditex Group, Inc. [“Creditex”] for a combination of stock and cash. Creditex is a market leader and innovator in the execution and processing of credit default swaps [“CDS”] with markets spanning the U.S., Europe and Asia. Creditex is a leader in the most liquid segments of the CDS market, including indexes, single-names and standardized tranches.

The transaction consideration will total approximately $625 million, comprising approximately $565 million in the Company’s common stock and $60 million in cash, as well as a working capital adjustment to be finalized after the closing of the transaction. Upon the closing of the transaction, estimated to occur in the third quarter of 2008, Creditex will be a wholly-owned subsidiary of the Company. The transaction has received FSA approval, as well as early termination of the applicable Hart-Scott-Rodino waiting period, but remains subject to U.S. Financial Industry Regulatory Authority approval.

Creditex and their subsidiary Markit were the outfits that recently liquidated Fannie-Mae’s (FNM), Freddie Mac’s (FRE) and Lehman Brothers’ (LEH) Credit Default Swaps - making the ICE the clear leader for now. Prior to the merger with the ICE, Creditex/Markit agreed to be the platform for trading CDS’s on the NYSE, increasing the opportunity for ICE to grab market share from the other players vying for a piece of the CDS market - viz. the CME/Nymex (CME), Knight/Trimark Group NITE, The NYSE/Euronext (NYX), and the Nasdaq/OMX Group (NDAQ).

Pick #2 is the CME/Nymex Group - for its sheer size, experience in bringing to life new markets, and for ensuring liquidity. CME has teamed up with the Citadel Group. I am picking the ICE ahead of the CME - for the simple reason that the ICE is hungrier, and made the first move by buying up Creditex/Markit.

Pick #3 is the NYSE/Euronext. The reason I picked them at #3 is because of its existing relationship with Creditex/Markit.

Pick #4 is the Nasdaq/OMX group AND the Knight/Trimark Group. Both companies want to use an OTC platform to trade CDS’s - which I think will be the weakest product in a market - where deals are driven by inside information, or a very deep understanding of the ability of a specific issuer of a debt instrument - to default on a loan. The basics of CDS’s and what is important in the inception of a trading market/platform were discussed in Part I.

Since all five of these stocks have been beaten down in recent months, I think that all of them [except the Knight/Trimark Group] offer adequate double digit per year [annualized] capital gains looking forward three to five years, but my #1 pick is the ICE, with the caveat that the stock will probably be weak in the months ahead due to the tanking of commodity prices - which will put pressure on the amount of contracts traded on ICE’s platform. Meanwhile, the biggest driver of CME’s and ICE’s stock in the next few months will center around the inception of and the beginning of trading of CDS’s. I expect ICE to be the first to market. (Markit was already responsible for the liquidation of FNM, FRE and LEH's CDS's).

There are significant issues that need to be solved - regarding margin and equity requirements for traders, and the central counter-party model suggested by both the ICE and the CME [I think] will rule at least in round one of CDS trading, as the market is filled with distrust. Plus, the four issues outlined in Part I are yet to be solved. Re-hashing the issues, they are:

a. What kind of market? Central counter-party or OTC?

b. Can all defaults be cured by margin/equity requirements? Will these kill the CDS market - or add liquidity by adding transparency?

c. How much will the margin requirements be? How can they be enforced?

and finally

d. Clearing.

I will discuss earnings, valuation and other traditional valuation [of ICE and CME] in a subsequent article.

Disclosure: No positions in all stocks mentioned above [yet].

Comments

[whidbey:]

Very interesting. Clearly they (ICE) have their eye on the future, but just how active will the CDS market be? Some think it is breaking slowly as things cool down, others think it reaches a grand crash. I think we don't know, but much seems to depend on how the world sees things over the next year: Emotionally or more pragmatically.

2008 Oct 23 01:06 AM

[FourBrane:]

Aside from any likely share of the CDS market, volumes handled by ICE are still going up right now as the stock's price plummets. To date, October oil futures and options volume is 10% above an average month this year, while combined U.S. commodity, FX and Russell trading is up 37%. I don't have the patience to calculate the Canadian volumes as they don't report it conveniently.
Still, ICE is very thinly traded, so it cannot seem to get a stable price and that makes owning it (as I do) a difficult exercise in fear control. This stock bucks harder than a wild horse and many a rider has recently been thrown off.

2008 Oct 23 10:08 PM