The credit derivatives market is poised for rapid growth in 2005 following the successful merger last year of competing credit default swap indices.

This is the confident prediction of bankers and traders, who foresee the expansion of trading in so-called "second-generation derivatives" such as options and first-to-default baskets and the launch of an index futures contract.

Fulfilling these forecasts will depend on the absence of any serious market upsets. Some observers fear that the diffusion of risk that is possible from credit derivatives could lead to the market becoming concentrated with participants that do not fully understand what they have taken on.

However, there can be no denying the boost given to the trading of credit default swaps - in effect, a means of insuring against or taking exposure to, credit risk - by the creation of iTraxx last April.

The creation of a single family of credit default swap indices known in Europe as Dow Jones iTraxx and in the US as the DJ CDX index allows investors to hedge or take a view on the broader credit market or on specific sectors.

Measuring volumes is made difficult by the fact that this is an over-the-counter market, so there is no central point at which deals are counted. Market participants estimated that €1,000bn of index value had been traded by the end of the summer and that this number could have doubled by the end of last year.

This greater liquidity has led to a rapid tightening of bid-offer spreads. The two earlier indices had spreads of five to 10 basis points while the spread on the new European index can be less than one basis point.

In spite of this growth in liquidity, Deutsche Bank calculates that only 40 per cent of the parties that trade credit default swaps make use of the index because of the practical difficulties that risk managers have in accounting for them.

"We call it an index but from a credit perspective it is a bunch of single names and some clients need credit lines for every name," says Marcus Schüler, head of integrated credit marketing.

"That is time-consuming. Ideally a credit department would look at it as one single product representing a broad, diversified exposure to the overall credit market," he says.

One method of increasing the appeal will be the launch of an index future.

"Some clients cannot participate in over-the-counter derivatives but they can participate in futures traded on exchanges," says Andrew Palmer, global head of credit derivative marketing at JPMorgan.

Before a futures contract can be created, a decision must be made on whether to opt for cash or physical settlement of the contract.

For physical settlement to take place - most bonds are physically settled - the market needs to create a funded note, in effect a bond version of a credit default swap.

"You need a funded note that is liquid," says Charles Longden, head of credit market making at ABN Amro. "It would trade like a normal bond and would mirror what is in the CDS indices."

The banks that backed the creation of iTraxx are working on plans for a funded note and expect to launch it early next year in time for its use in conjunction with the March "roll" - when indices are adjusted to ensure they include the most liquid underlying credits.

Crucial for the effective workings of a futures market is that the underlying note achieves sufficient liquidity.

Alongside preparations for index futures, the banks are also working on plans for regular fixings of index prices, on the lines of the daily fixing of the London interbank offered rate (Libor), the short-term interest rate at which commercial banks agree to lend to each other.

A fixing would give professional investors greater confidence in the prices at which they were dealing and would open the market to the retail investor, who is protected by much tighter regulation.

The logical outcome of the growing liquidity of the credit markets and acceptance of the indices is that they be used to price new bond issues and some bankers expect this to happen this year.

"New issues used to be priced off government bonds, then off mid-swaps," said Mr Longden. "But if you have a credit index that is more relevant than the government yield curve, you could price an auto issue off the auto sector index."

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