Vol 3 (2006) - Issue 4

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Credit Derivatives: An Untested Market

The explosion in use of credit derivatives has occurred in a historically calm economic climate. Defaults and risk premiums are at all time lows. Systems, procedures and risk management are yet to catch up with credit derivative growth, and no economic crises have occurred to stress the system. But what happens when one does, how will the system cope and what could the potential outcome be?
The credit derivatives market began in the early 1990s. By the end of 2005, the notional amount of credit derivatives had grown to a USD 17 trillion market. As the market for credit derivatives has grown, the participants in the have also increased, now including banks, broker/dealers, hedge funds and insurance companies.
Since credit derivatives are private contracts between two parties designed to transfer credit risk from a buyer of protection to a seller, structures can be tailored to needs of an investor. Initially, structures were limited to credit default swaps and total return swaps. In a credit default swap, one party agrees to sell protection to another party on a specific reference entity for specific credit events. In a total return swap, one party makes payments to another to receive the return on a particular asset, or portfolio of assets. For a single asset such as a bond, the return would include both the coupon plus changes in market value.
In order to meet the expanding needs of the various market participants, the credit default structure continue to evolve. For example portfolio credit swaps, or synthetic collateralised debt obligations (‘CDOs’), were divided, or tranched, into the levels risks ranging from super AAA rated tranches to the first loss, or equity tranches. These transactions can be on either standard baskets, such as CDX or iTRAXX, or can be bespoke with custom baskets of reference entities. Further advances include made for portfolios of CDOs, known as CDO2s, and nth-to-default baskets, where an investor is exposed to n number of defaults from a portfolio of reference entities. Growth in this market has been driven by five key factors:
1. Investors searching for returns. Credit derivatives were a new product offering higher returns both to the investor and the arrangers.
2. Increasing levels of liquidity in the market. More and varied institutions have gained or reduced exposures using credit derivatives.
3. Defaults on debt have been at all time lows. The lack of defaults has increased confidence in the market and has limited the apparent downside for many participants. Would these same participants have been as interested in a period when far more of their investments were defaulting?
4. Changing capital requirements for banks. Under the provisions of Basel II, many market participants have been looking to reduce their capital at risk. Credit derivatives can help them reduce the capital tied up in investments, allowing that capital to be put to other uses.
5. Profitability of the contracts. Any new product has a higher level of profitability associated with it. As the product becomes more commoditised, the price to the arranger reduces.
As this market has increased, certain risks have arisen in the area of market and operational risk.