Canadian firm brings non-derivative alternative to credit default swaps to the United States

By Emma Trincal

New York, July 16 – DelphX Capital Markets Inc., a Toronto-based technology and financial services company, has created two new proprietary products designed to provide an alternative to credit default swaps for a wide range of institutional investors whose mandates may limit their participation in the derivatives market. The firm’s vision is to create a new credit market.

Breakthrough

The first product consists of Covered Put Options (CPOs) whose holders get secured default protection for underlying corporate, municipal and sovereign bonds. Akin to a CDS buyer, the buyer of a CPO receives credit protection in return for the payment of a premium upfront.

The second security, called Covered Reference Notes (CRNs), enables credit investors to take on the default risk exposure of a single underlying security in exchange for enhanced yield, which would be the equivalent of writing CDS.

But there’s a major difference.

“Since the products are securities, not derivatives, they are not subject to the disclosure requirements imposed on CDS, DelphX chief executive officer Patrick Wood told Prospect News in an interview.

“CPOs and CRNs do exactly what a CDS do without the mandate restrictions. We think they will provide a great alternative to swaps.”

This may be the start-up phase of a brand new credit market, sources said.

“We expect to be issuing CPO and CRN securities by the fourth quarter of 2021,” Wood said.

“All CPO and CRN will be issued in the U.S. We intend to expand to other markets in 2022.”

Scaling up

“There is a demand for insurance against credit risk but so far there has been only one option: credit default swaps,” said Wood.

“The problem with swaps is that most of the buyside, I would say 90% of it, cannot buy or write CDS because of regulatory restrictions on derivatives.”

DelphX will market its securities to investment managers, mutual funds, pension funds and family offices.

Insurance companies, which already are the largest issuers of CDS may be the prime market for CRNs, he noted.

“They will invest in CRNs and assume the default risk for the same reason they write CDS: yield enhancement,” he said.

Making a market

All CPOs and CRNs will be collateralized and held by a “major custodian for structured products in the U.S,” said Wood, who declined to name the institution.

“The enhanced yield is achieved by combining the premium paid by CPO investors with the yield on the collateral, which is invested in Treasuries,” he said.

Delphx will issue these securities under its wholly-owned special purpose vehicle named “Quantem.”

The company’s broker-dealer, DelphX Services Corp. will enable dealers to structure, sell and make markets in CPOs and CRNs on the 144A market. DelphX Services Corp. is registered with the Financial Industry Regulatory Authority and directly regulated by the Securities and Exchange Commission.

“We’ve had a number of advanced talks with Wall Street for the adoption of the new securities, including with asset managers, broker-dealers and investors in the credit space,” Wood said.

144A versus OTC

The securities will trade on the 144A market, which gives them another advantage over swaps, which trade over the counter, he added.

“Because it trades on the 144A market, the collateral is fully transparent. You don’t have that kind of transparency in the derivatives market.” He said.

In addition, CPO and CRN investors are not subject to counterparty risk.

“When you buy a CDS, you are betting on the reputation or the rating of the counterparty,” he said.

“In our case, investors have exposure to Treasury bonds with the full backing of the U.S. government.”

As a result, Wood said he expects the new securities to provide superior liquidity.

“There is a great likelihood that our platform could generate a secondary market. Traders could arb CDS with CPOs.”

Wood’s visionary plan is to offer a more “subtle way” of doing CDS.

“A lot of people had a bad experience with CDS,” he said.

“But we’re fully collateralized.

“The counterparty is gone. You don’t rely on the balance sheet of the issuer. You rely on the U.S. government to make you whole.”

Projected revenues

DelphX’s revenue strategy consists of capturing small shares of two gigantic credit markets.

The first bullet point is to convert some of the existing $1 trillion corporate investment grade CDS market.

Several revenue scenarios project gains in market shares of 0.5% to 3% of this market, which would generate for DelphX between $20 million and $300 million in annual revenues, according to a company slide obtained by Prospect News.

The second strategy is to go after the U.S. corporate bond market.

"We're looking to capture some of that market as well. CRN investors look for enhanced yield and, in some cases, the yield is higher with our CRNs with the exact same risks," he said.

Annual revenues, according to the company, based on the 0.5% to 3% market shares would be between $107 million to over $600 million, the slide showed.

“That's because CRN investors receive the premium paid by the CPO holders as well as the yield on the collateral which is invested in U.S. Treasuries,” he said.

“As the market for the new securities expands, other types of collateral assets may be used in the future.

“We are starting with T-bills. We want to start standardized. Later on, we will build into other assets.”

Advisory board

The Company is assembling a team of bond and financial industry experts to spearhead the launch of the CPOs and CRNs.

Keith Styrcula, chairman of the Structured Products Association, joined the company’s advisory board in March, according to the company’s website.

Joe Castelluccio, a veteran bond trader, specializing in credit-linked notes joined the advisory team last month.

DelphX Capital Markets Inc is a publicly traded company with shares listed on the Canadian TSX Venture Exchange.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.