To quote Warren Buffet, the American investor, businessman and philanthropist: “Derivatives are like hell – easy to enter and almost impossible to exit.” Although this characterisation may be glib, it does touch a nerve. In the financial world where risks are high and revenues are relatively low, credit derivatives become an attractive option for insurers, hedge funds and commercial banks. The attractiveness of credit derivatives can be attributed to the fact that such instruments offer a way to manage portfolio risk for buyers, promise high-yield returns for sellers and, for the global financial system as a whole, they could theoretically diversify and diminish risk, at least in theory.
The demand by financial institutions to hedge and diversify credit risk gave birth to credit derivatives. A credit derivative can be defined as an agreement designed to shift credit risk between the parties; its value is derived from the credit performance of one or more corporation, sovereign entity or security. These instruments have now become a major investment tool. Almost all credit derivatives take the form of the credit default swap (CDS), which transfers the default risk of one or more corporations or sovereign entities from one party to the other.
The credit derivatives market segment has probably been one of the most innovative and fastest growing in recent years. Most notably, during the last mid-year review, International Swaps and Derivatives Association (ISDA) recorded a 52% rise in the notional outstanding amount of credit default swaps, which rose to US$26 trillion. Moreover, according to the Securities Industry and Financial Markets Association (SIFMA), the issuance of collateralised debt obligations almost tripled between 2004 and 2006, amounting to US$489bn in 2006. The rapid development and the share of this market segment is a very important feature of today’s global finance industry. On a commercial level growth continues to outstrip expectations. However, on a regulatory level the size and relative inexperience of the market presents many challenges to the industry.
Source: BBA Credit Derivatives Report 2006
Market Sentiments
The supporters of credit derivatives believe that they have actually have a stabilising effect on the credit markets by infusing liquidity and enabling wider distribution of risk. Contrary to that, the critics of credit derivatives say that they provide a mechanism for sophisticated global banks to unload their unwanted credit risk on unsuspecting investors. Moreover, they say the instruments lack transparency and are too dependent on a small group of large banks. But, while these critics suggest that credit derivatives market is a disaster waiting to happen, other market participant scoff at that notion. A survey conducted by Fitch in 2007 covering some 65 institutions reported that there was a concern on how smoothly the credit derivatives market would deal with a turn in the credit cycle. Recently, the credit markets have been shaken up by a spate of defaults in the US sub-prime mortgage market. This shake up has dented market sentiment and the risk appetite of financial institutions.
The story behind the fall
Though credit derivatives were thought to be an efficient risk management tool, they were in some part responsible for the ebb of large banks/institutions. Many say that the Federal Reserve’s bailout of Bear Stearns on 17 March was motivated, in part, by a desire to keep the unknown risks of the bank’s CDSs from setting off a global chain reaction that might have brought the entire financial system down on its knees. The Fed’s fear arose from the fact that they hadn’t adequately monitored counterparty risk in CDSs probably had no idea of what might happen. However, many market observers believe that faulty practices in lending by financial institutions and not credit derivatives were the cause behind the downfall.
Credit Default Swaps: A Reason for the Current Financial Crisis?
Until last year, CDSs were hailed as a wonder of modern finance. These derivatives allowed sellers to take on new credit exposure and buyers to insure against companies or governments failing to honour their debts. The notional value of outstanding CDSs exploded from almost nil a decade ago to US$62 trillion at the end of 2007 – although it slipped to US$55 trillion in the first half of this year and has since continued to fall. Traded privately, or over-the-counter (OTC), by banks, they seemed to prove that large, inventive markets could function perfectly well with minimal regulation.
However, since September a wave of large defaults and close calls involving faltering banks, brokers, insurers and America’s giant mortgage agencies, Fannie Mae and Freddie Mac, has sent the CDS market reeling. Shake-ups with derivatives are common, but CDSs have been causing particular concern. One reason for this is the broad threat of ‘counterparty risk’ – the possibility that a seller or buyer cannot meet its obligations. Another is the unstable state of back office structures, which were neglected as the market boomed. A third is that swaps can be used to hide credit risk from markets, since positions do not have to be accounted for on balance sheets. They make it beguilingly easy to concentrate risk.
However, some believe that the root cause of the crisis was bad mortgage lending and not derivatives, and that swaps on sub-prime mortgages grew unstable because the loans themselves were risky. CDSs may not have been the root cause of the current state but it definitely amplified the crisis.
Throughout 2007, regulators and other financial market participants had been hinting that credit derivatives could induce a variety of problems, including: lack of transparency, information asymmetry and counterparty concentration. Repeatedly there have been concerns raised by different rating agencies and the Bank for International Settlements (BIS) questioning the integrity and fairness of the credit market.
This brings us to question certain facts about the credit market: Was there a lack of transparency in accounting? Was lack of transparency responsible for covering up firms who had recently suffered credit derivatives losses stemming from corporate defaults? Did large banks selling credit risk know much more about the risk than the investors to whom they sold it, and were they taking advantage of gullible counterparties? Was it a question of too few players handling the majority of credit derivatives trades, and what would have happened if one of the significant players defaulted or pulled out of the market?
There is growing consensus that the flexibility provided by derivatives, whereby risk can be traded separately, has the potential to facilitate risk sharing, enhance the efficiency of risk management and promote market completeness. Credit derivatives, in particular, may offer investors a tool enabling them to exploit their comparative advantage in terms of assuming different types of risk, as well as the corresponding remuneration for these risks. Banks are using credit risk transfer instruments, including securitisation, to distribute credit risk exposures acquired in their lending business to non-banks. All innovations, however, encompass advantages as well as risks. The key question is under what conditions do credit derivatives enhance the resilience of the financial system.
A few aspects of the credit derivative market that need to be considered are:
The great transparency dilemma
No one really knows who has borne the credit derivatives losses resulting from a string of recent corporate defaults due to a lack of transparency in accounting procedures. This lack of understanding is, in fact, a major concern among regulators and market overseers.
In April this year, the Joint Forum of the Basel Committee on Banking Supervision (BCBS), an international group of banking, insurance and securities regulators, reported that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world. The committee further stated that: “It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred. It can be difficult even to quantify the amount of risk that has been transferred.” While banks ask protection sellers to put up some money when making the trade, sellers of protection aren’t required by law to set aside reserves in the CDS market. There are no industry standards.
CDSs are generally used to build up leverage and therefore increase the amount of risk in the financial system – rather than just redistributing it. Some market analysts also agree that without an adequate disclosure about risk positions, significant credit risk exposures can build up unchecked at certain financial institutions. This could prove particularly troublesome for institutions that deal with hedge funds.
Fitch had asked some 50 hedge funds for information about their use of credit derivatives, but none responded. But without hedge fund regulation, it is unlikely any information about the trading activities of these largely unregulated funds will be forthcoming.
An uneven playing field
Another common criticism of credit derivatives is that there is substantial information asymmetry in the market. In layman’s terms, this means that large banks selling credit risk know more about that risk than the investors to whom they sell it. For example, if a bank extends credit to a client and then hedges its exposure to the client using a credit derivative, the bank’s counterparty may not be informed about the client’s credit quality as well as the bank itself.
These concerns have, however, been at least partly addressed by ISDA, Bond Market Association (BMA), International Association of Credit Portfolio Managers (IACPM) and Loan Syndications and Trading Association (LSTA). In 2003, these groups jointly developed guidelines and procedures for banks in their handling of so-called material non-public information (MNPI). ISDA says these guidelines will help build confidence among investors that information obtained by a bank (in the ordinary course of their lending or other relationships with a company) is not inappropriately shared with or used by other business units or staff in the same bank.
Too much power, too few players?
The fact that a few major banks account for most of the trading in credit derivatives is yet another cause for concern for regulators and market observers. To understand the severity of this counterparty concentration problem, consider that the top 10 global banks are involved in 70% of all credit derivatives transactions. If one of those banks decided to stop trading credit derivatives, the market would immediately lose 10% to 15% of its liquidity. The market really needs more players to ensure its continuing health.
What’s more, in the unlikely event that one of these firms could not fulfil its credit derivatives obligations, market confidence could take a huge hit. However, the credit derivatives market does not seem to have suffered adversely from the exit of some of the biggest insurers and re-insurers – including some of the largest sellers of credit protection.
Conclusion
Market observers across the world continue to monitor the credit derivatives market and several believe it poses more of a risk to financial stability than other markets – merely because it is relatively young and fast growing. But the fact that they have ‘behaved as advertised’, as opposed to the cases of Enron and WorldCom, has convinced most people in the industry that credit derivatives are not a disaster waiting to happen. Still, the conditions as they stand caution that major banking players in credit derivatives must work harder to improve transparency – via the voluntary disclosure of more information – if they want the market to flourish.
The challenge is to work towards an adequate transparency framework. More and improved data on net credit risk exposures and on the concentration of positions – which tend to build up easily in highly leveraged and opaque markets – could help to mitigate sizeable shortcomings in both counterparty and systemic liquidity risk management. In fact, such data could help market participants and competent authorities to value, price and manage more effectively the increasing risks posed when investors behave in a homogenous way. However, there is as yet no broad consensus on how such a framework would be best implemented in order to provide timely and relevant information.
It is crucial to bear in mind that the problem is not credit derivatives instruments per se, but how they are used, and particularly the size, distribution and concentration of risks they allow. Increased transparency on these three issues could be useful for risk managers in both the private and public sectors and for the market in general.
Bibliography
“Credit Derivatives: Where’s the Risk?” Atlanta Fed’s 2007 Financial Markets Conference
Keynote address by Jean-Claude Trichet, president of the ECB at the 22nd Annual General Meeting of the International Swaps and Derivatives Association (ISDA).
BBA Credit Derivatives Report 2006
‘The great untangling’ – Economist
BIS Quarterly Review, June 2008
Disclaimer: The article is purely a contribution by the author and does not represent any fact, position nor opinion of 3i Infotech.