Credit derivatives house of the year: Barclays

Risk Awards 2020: UK bank showed flow strength in Thomas Cook default – and product range is growing

Adeel Khan

The collapse of Thomas Cook in September left up to 600,000 holidaymakers stranded and in need of rescue. Investors holding the company’s debt and derivatives feared they would suffer the same fate.

The UK tour operator had built up a $2.1 billion debt pile, consisting of bonds, bank loans, credit lines and letters of credit – much of which was sitting in the hands of nervous portfolio managers.  

As debtholders scrambled for protection, rumours were swirling that some dealers were reluctant to trade the company’s credit default swaps (CDSs) after racking up trading losses on the contracts, as well as those of Rallye, the parent company of French retailer Casino, which entered bankruptcy protection in May.

A last-minute effort to recapitalise the company via a debt-for-equity swap would have rendered the CDS worthless in any case. And when Thomas Cook eventually filed for Chapter 15 bankruptcy protection in the US on September 17, it did not explicitly state insolvency, adding to the uncertainty for CDS holders.

Through it all, the credit derivatives traders at Barclays held their own. “They were on top of it,” says a hedge fund manager in London. “We traded a lot of Thomas Cook and they were our top counterparty.”

Adeel Khan, global head of credit at Barclays, sees the complexity of the Thomas Cook default as a sign of things to come. 

“As we reach the end of the credit cycle, we’re going to have to deal with a lot more idiosyncratic single-name events,” he says. “It’s the nature of the credit product – these issuers could have revolvers, they could have letters of credit, they could have CDS contracts outstanding, they could be in indexes. The situations you’re going to deal with will not be straightforward. They will be very complex.”

In the case of Thomas Cook, Barclays was making markets across the board. “We were very active in the bank debt, we traded the revolver, we were active in the CDSs, and we had exposure to that credit in indexes,” says Khan.

As the company barrelled towards bankruptcy, and trading grew more frenzied, Barclays was mindful of any efforts to manufacture a default or otherwise rig the payouts on CDS contracts.

The firm was an active member of the working group, led by the International Swaps and Derivatives Association, tasked with stamping out such practices following the backlash over Blackstone’s controversial trigger-for-financing deal with Hovnanian. The working group proposed a new causation test to determine whether a failure-to-pay event will trigger payouts on CDSs. The fix is being written into Isda’s standard rulebook for credit derivatives, known as the definitions.

As we reach the end of the credit cycle, we’re going to have to deal with a lot more idiosyncratic single-name events

Adeel Khan, Barclays

Khan says dealers and their clients have a collective duty to protect the integrity of the CDS market. “At the end of the day, CDSs are there to do a job in a credit event, and if they stop doing that, then it creates a very negative perception of the product.”

The possibility of foul – or at least fishy – play reared its head with Thomas Cook when an investor that sold CDSs reportedly offered to stump up £150 million to keep the company afloat, but only if the deal was structured in a way that did not trigger payouts. Some funds holding CDS protection were also criticised for threatening to block the rescue efforts of other creditors.

Khan says some of the machinations leading up to the Thomas Cook bankruptcy once again underscored the need for an asset package delivery mechanism – which allows for a broader range of assets to be delivered into CDS auctions following a restructuring – for European corporates. Packaged delivery is already permitted for sovereigns and financials.

CDS holders ultimately got their payouts without much controversy after Thomas Cook filed for liquidation on September 23.

Khan estimates the firm handled 25% of all CDS trades on Thomas Cook. That was no mean feat and required a co-ordinated effort, with all hands on deck.

“To provide consistent liquidity during these events, you need to bring your trading, sales and research teams together,” says Khan. “You need deep expertise and knowledge in all of those different aspects of a transaction to offer a strong service.”

That’s no more than clients have come to expect from Barclays. When CDS spreads on Turkey widened to more than 500 basis points in May, after the results of mayoral elections in Istanbul were annulled, Barclays had around 30% of the market share in the contracts. It was equally active in a number of other heavily traded credits. “They generally offer the best research and liquidity,” says an asset manager in US.

CDSs are there to do a job in a credit event, and if they stop doing that, then it creates a very negative perception of the product

Adeel Khan, Barclays

The flow business has long been Barclays’ strongest suit in credit derivatives. The firm claims to see more than 30% of the volume in 13 CDS indexes globally, including options trades. In single names, it has a market share of more than 50% in 36 tickers across Europe, Asia and the Americas, and eight of the firm’s traders handle more than 20% of the volume across all the single names they cover.

Over the past 18 months, the bank has continued building on that core strength. Khan splits the credit business into four main verticals – flow trading, investing, financing and structuring. “Over multi-year periods, the opportunity set changes and evolves depending on what is happening in the market,” says Khan. “Today, the demand for structured financing for credit collateral is very high. It’s critical to be in all of those verticals to understand how they interact with each other.”

That process began in 2012, when the firm helped re-start the collateralised loan obligation (CLO) business in Europe. Since then, it has consistently been a top-two house in underwriting CLO securities in the region. Last year, it hired John Clements, the former co-head of Citi’s CLO business, as head of US origination and syndication. It also brought in two former Natixis bankers, Mike Hopson and Lorraine Medvecky, to lead its middle market efforts, also in the US. Within 18 months, Barclays had risen from number 15 to number 3 in the US CLO business.

The product expansion continued with the re-launch of credit-linked notes (CLNs) and bond repacks in 2018, followed by its re-entry into total return swaps (TRSs) in the first half of 2019 and derivatives linked to the CMBX index of commercial mortgage-backed securities.

“We’ve added credit-linked notes, repacks and CMBX. These are products we de-scaled after 2009 and the question has been, how can we add them back to our product suite?” says Khan. “TRSs are a product that was shut off in 2008. And we’ve just turned them on again.”

The client response has been positive. Barclays executed almost 150 CLN trades through November 14 of 2019, compared to around 25 over the same period in the prior year. Demand for TRSs has been even stronger, with more than 1,000 iBoxx trades in Europe and the Americas so far this year, versus roughly 30 in 2018.

Arguably the biggest project of recent years, though, has been the expansion of term or structured financing of credit assets. 

Today, the demand for structured financing for credit collateral is very high

Adeel Khan, Barclays

“Overnight repo credit financing is a very important business for us. But we didn’t do a lot of term or structured financing until recently. We started that business last year also,” says Khan.

Structured financing is demanded by a variety of credit clients, including loan originators, private equity firms, real money investors and smaller banks. The transactions are collateralised with a broad array of credit assets, from bonds to leveraged loans or even hybrid securities, such as preferred shares. The financing terms could be as long as five or six years.

Unlike short-term repo, where the primary concern is credit risk, structured deals hinge on pricing the underlying assets that are being financed.

The business is not without risks and Khan reckons the terms being offered by some competitors are too generous. Barclays has provided around $1.5 billion in structured financing against credit assets since 2018, but Khan says the firm is being careful.  

“We’ve grown that business [term financing] steadily,” he says. “In that business, there is exuberance and the terms are starting to get stretched in parts of the market. The risk is a little bit bigger than the market perceives it to be. So we’ve been a bit cautious, but we’re in the market and it’s an important offering for us as clients are demanding the product.”

For all the new launches, relaunches and roll-outs, Barclays still has some gaps in its product line-up. Notably, it does not trade CDS index tranches, or bespoke collateralised debt obligations (CDOs).

Index tranches provide exposure to a portion of the index loss distribution, and are used by hedge funds and other sophisticated investors to implement curve trades and relative value positions. Index tranche volumes reached $200 billion in 2018, according to Quantifi, a risk management software vendor.

Bespoke CDOs allow a client to handpick the credits in the structure, which is then sliced up and distributed to investors. Issuance of these products is expected to top $100 billion this year, with the likes of BNP Paribas, Citi and JP Morgan leading the charge.

Barclays is currently unable to handle these products.

“We turned off our correlation pricing model, and that’s the biggest hurdle for getting back into CDS tranches,” says Khan. “Now, we are looking at the investment to turn it back on, and we are actually implementing that. We prioritised things like TRSs and algo trading in cash bonds because we felt the demand from clients is greater in those areas.”

But the firm is in no rush, especially when it comes to issuing full capital structure bespoke CDOs. “We do have some reservations about full-cap CDOs,” says Khan. “What if the client wants to exit one part of the trade? Our business model is based on consistent liquidity provision to our client base.”

Index tranches, meanwhile, could find their way into the product line-up if clients demand it. “All the products that we were not very active in – structured financing, CLNs, CMBX, TRSs – we’ve pretty much added all of them to our products suite in the last 12 months, which shows you we are serious about having a pretty broad credit business,” says Khan.