IMF issues credit derivatives warning

The International Monetary Fund (IMF) believes the lack of financial disclosure and transparency in the credit derivatives market has the potential to increase market risk, as participants find it more difficult to gauge the depth of credit deterioration caused by credit events.

In its latest Global Financial Stability Report, the IMF warned that increased reliance on credit derivatives may be detrimental for institutions still not properly experienced in using the relatively nascent market.The IMF report said a lack of transparency in credit derivatives reporting means it is becoming more difficult to gauge where institutional credit risk is being transferred. Regulatory arbitrage, which is a main driver of the credit derivatives business, is leading more banks to transfer credit risk to institutions like hedge funds, insurance companies and pension funds. Many of these entities lack the regulatory checks and risk management culture of banks.

The study quoted figures taken from the Bank of England’s 2001 Financial Stability Review and the 1999/2000 British Bankers Association’s credit derivatives survey. These reports showed that insurance companies, hedge funds and corporates make up 36% of the total protection sellers' market.

Garry Schinasi, the IMF's financial markets stability division chief, and one of the authors of the report, told RiskNews: “There is a new set of sellers of protection that haven’t managed a lot of credit risk [before]. It is possible that they could be mispricing it.”

Schinasi added that this could lead to a greater amount of credit risk being transferred to investors that ultimately lie at the end of the credit chain.

The IMF report also said the leveraged characteristic of most credit derivatives could deepen the effects of credit events. But the IMF acknowledged that the credit derivatives market does have its benefits in controlling credit risk, and has stood up well to the Enron and Argentinian crises.