Untangling credit derivatives

market view

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Valued by the most recent International Swaps and Derivatives Association survey at year-end 2004 at $8.24 trillion, and forecast to double in size by 2007, the global credit derivatives market is by any standards sizeable. Yet it is still a small proportion of total derivatives trading: over-the-counter derivatives trading was estimated to have passed the $100 trillion mark in terms of notional outstanding sometime in 2002.

This relative comparison should not of course detract from this market’s importance. The sheer growth of the market – more or less doubling every year from $180 billion in 1997 – and its complexity will keep the best financial analysts and lawyers on their toes for the foreseeable future.

The spread of credit derivatives, and the subsequent blurring of boundaries between market and credit risk, has important implications for the way we think about credit, and those that provide it. Some see the day when the initial providers of credit become effectively agents, specialised in credit risk but unwilling or unable to hold large amounts of credit risk on their own balance sheet.

That vision may be fanciful but already the ultimate bearers of risk are becoming more diffuse, although also harder to pin down. As the provision of debt moves beyond traditional banking systems to markets with a variety of funding sources, the result is (perhaps arguably) increased transparency and tradability of credit. In other words more efficient and consistent pricing across funding sources including bonds, loans and equities.

This consistency should be good news for companies’ chief financial officers in creating their financing plans. But CFOs may, on the other hand, find their funding costs at the mercy of market developments they do not quite understand. Demand for, and sometimes the creation of, credit instruments allied to a firm’s performance becomes driven as much by investors’ desire to micro-manage the portfolio of risk they are holding – whether it be exposure to a sector, a country or a portion of the risk spectrum – as by fundamentals. A firm’s credit finds or loses favour dependent on its fit into others’ portfolios. Perhaps this could happen in a world of straightforward bonds as individual investors try to balance their portfolios; in the collateralised debt obligation (CDO) world, however, the audience is more widespread and the impact both faster and of greater magnitude.

These fundamental issues aside, there are also more immediate concerns. In addition to my day job as the director of markets at the FSA, I chair a group called the Joint Forum, which brings together international regulatory standard setters from the banking, securities and insurance sectors. In late 2003 the Joint Forum started looking at the transfer of credit risk between institutions and sectors. In particular, we were tasked by the Financial Stability Forum (FSF) to consider – unsurprisingly – the financial stability aspects of credit derivatives.

In plain language, the FSF asked whether institutions with sophisticated credit risk management skills were transferring their less attractive exposures to unwary investors in such large and concentrated amounts that the financial system was about to fall over. “Probably not” was our (sort of) happy answer. In our study we found limited evidence of mass transfers of credit risk to naïve institutional investors at present. That is not to say that we did not hear stories of international banks transferring their more risky exposures to regional financial firms in Europe and beyond. Our study showed, however, that the incidence of such transactions was limited and many new participants in the credit derivatives market had either upped the level of their expertise in credit risk management or withdrawn from the market after early exploratory forays.

This relatively benign assessment from an immediate financial stability perspective should not create a false sense of confidence. Other risk management issues are key. For example, complexity in credit derivatives requires real understanding, whether figuring out the default correlation risk in a CDO-squared or merely understanding what a seemingly straightforward rating does and does not tell you. Knowing the credit rating of the underlying reference entities when, for example, buying particular tranches of risk is not enough. I noticed a recent newspaper report on a new CDO based on emerging market debt that trumpeted investors’ relish at getting the wider spreads no longer associated with the underlying bonds – but only if they bought the equity tranche. Financial innovation is not some magic that can generate higher spreads out of thin air. Rather this tranche of the CDO has higher risk, hence the higher spreads.

Paper chase

Of course complexity alone does not pose risks. It is sometimes the simplest aspects of a fast-growing market that trip up one or more big players with potentially systemic effects. Paperwork is a case in point. Over the last year or so we at the FSA have noticed that the level of outstanding confirmations – produced by the seller of protection and sent to the buyer – has been rising fast. We felt so strongly about this that in February we wrote directly to the chief executives of firms involved in the credit derivatives market to encourage them in their already ongoing efforts to do something about it. We are now monitoring their response.

Information asymmetries – long features of the credit market and one reason why we have regulation – mean that banks, with their specific and ongoing inside information on clients, must take care not to misuse that information. Actively managed credit derivative instruments, where underlying reference entities are swapped in and out, hold benefits for clients, but increase the importance of effective Chinese walls.

The themes I have picked up here, and others, are all reflected in the Joint Forum’s report, which was released on March 18 (http://www.bis.org/bcbs/jfpubl.htm). We consulted widely on this report in the period from October 2004 through to January 2005 and have received useful input from market participants which is outlined in the report. The job now is for market participants and regulators to concentrate on how to take forward the recommendations in the report in order to take advantage of the very real benefits that the growth in credit derivatives is bringing.

Gay Huey Evans is director of the markets division at the Financial Services Authority

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