G L O B A L A S S O C I AT I O N O F R I S K P R O F E S S I O N A L S

C O V E R S T O RY

Credit Derivatives:
Smooth Stabilizer or
Ticking TNT?
Some critics believe that credit derivatives 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 the credit derivatives market is a disaster waiting to
happen, other market participants scoff at that notion. Contrary to adding risk to the
market, they say, credit derivatives have actually had a stabilizing effect, adding liquidity to
the credit market and enabling wider distribution of risk.
Emily Saunderson examines both sides of the debate. >>

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I
n 2002, credit derivatives were widely lauded as one of the
main reasons the capital markets withstood record levels
of corporate defaults without any major trauma. Indeed,
they had proved to be a solid risk management tool. But
throughout last year, regulators and other financial market par-
ticipants claimed that credit derivatives induced a variety of
problems, including: transparency deficiencies, information
asymmetry and counterparty concentration.
Similar concerns were raised in losses resulting from a string of recent corporate defaults.
reports conducted by Fitch Ratings, This lack of understanding is, in fact, a major concern
the Bank for International Settlements among regulators and market overseers.
(BIS), and the Centre for the Study of Financial In its 2003 report called “Credit Risk Transfer,” a BIS
Innovation (CSFI) – a UK-based think-tank. committee said “the information available at present is
Consequently, key questions about the integrity and fair- adequate neither to track the redistribution of credit risk
ness of the credit derivatives market have arisen. through the use of credit risk transfer instruments nor to
For example: Is there a lack of transparency in identify any resulting risk concentrations.”
accounting, and is this transparency deficiency covering The BIS says this is particularly important with regard
up firms who have recently suffered credit derivatives to credit-default swaps, because they can be used to build
losses stemming from corporate defaults? Do large banks up leverage and therefore increase the amount of risk in
selling credit risk know much more the financial system – rather than just redistributing it.
about that risk than the investors Some traders agree that without more disclosure about
to whom they sell it, and are risk positions, significant credit risk exposures could build
they taking advantage of less up unchecked at certain institutions. This could prove
knowledgeable counterparties? particularly troublesome for traders that deal with hedge
Are there too few players han- funds. “I can buy credit protection from a hedge fund, but
dling the majority of credit I do not know how leveraged it is in that position – (or)
derivatives trades, and what how many similar trades it has done with other counter-
would happen if one of the sig- parties - and that might present a problem if there is a
nificant players defaulted or default and the hedge fund has to pay out,” explains
pulled out of the market? Ian Linnell Mitch Braselton, managing director and head of global
While they recognize that structured products marketing for Europe, the Middle
there could theoretically be a crisis in the credit deriva- East and Africa at Bank of
tives market in the future, market participants generally America in London. “At the
suggest that these concerns are either misguided or over- moment, we deal with this risk by
stated. Moreover, they say that by dispersing credit risk completing extensive due dili-
among a larger number of firms, credit derivatives have gence on our counterparties and
actually had a stabilizing impact on the market. sometimes asking for collateral.”
But credit derivatives still topped the 2003 “Banana But without hedge fund regula-
Skins” report from the CSFI, which tracks financial mar- tion, it in unlikely any informa-
ket participants’ perceptions of the top 30 risks to banks. tion about the trading activities of
And critics suggest that if these concerns are not these largely unregulated funds
addressed soon, they may at least hinder market devel- Mitch will be forthcoming. Fitch asked
opment – and, in the very worst case, pave the way for a Braselton some 50 hedge funds for infor-
credit derivatives catastrophe. mation about their use of credit derivatives and, rather
Transparency Troubles unsurprisingly, none responded.
Due to a lack of transparency in accounting, critics claim, Nevertheless, some industry observers say hedge
no one really knows who has borne the credit derivatives funds will never present a systemic risk to the credit

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derivatives market, because they are relatively small the investors to whom they sell it. For example, if a
players. “Concern about a lack of transparency about bank extends credit to a client and then hedges its expo-
who holds what risk is justified, because it could hide a sure to that client using a credit derivative, the bank’s
build up of systemic risk. But this problem does not par- counterparty may know less about the client’s credit
ticularly relate to hedge funds, because they just are not quality than the bank itself.
taking on the huge positions,” says Thomas Jasper, One regulator who responded to the CSFI’s study
chief executive of Primus Financial Products, a New summed up his concerns in the following statement:
York-based credit derivatives operating company. “The revolution in credit risk transfer techniques has
Portfolio transparency is certainly important when it brought strong benefits to risk management, but gives
comes to the largest credit derivatives players, such as concern that those segments of the market that have
the major investment
banks, commercial
banks, broker dealers,
insurance companies
and credit-portfolio
managers. And since
these institutions are
regulated, tighter
reporting standards
may eventually pro-
vide a stepping stone
to greater transparen-
cy.
At the moment,
however, it does not
appear as if IAS 39 or
IAS 32 – international
accounting standards
which require fair
value accounting for
derivatives which are
not genuine hedges –
will significantly
improve transparency.
In fact, critics say The chart (above) analyzes the effect of credit derivatives on financial statements, com-
these standards, due paring financial institutions with varying levels of CD holdings. It was extracted from a
to come into effect in September 2003 Fitch study on global credit derivatives.
2005, will produce
only modest improvements in data about risk redistrib-
ution. bought risk do not fully appreciate what they have
taken on.”
An Uneven Playing Field Ian Linnell, the London-based managing director of
In September 2003, Fitch produced a report entitled Fitch Ratings’ credit policy group for Europe, says
“Global Credit Derivatives: A Qualified Success.” The asymmetry is not really a problem at the moment. Most
report, which was based on information collected from credit derivatives trade is in investment-grade credits,
181 institutions active in credit derivatives, was favor- he notes, and there is plenty of publicly available infor-
able – but also highlighted several areas of concern that mation about such instruments.
Fitch shares with other organizations. “Credit derivatives allow for more efficient allocation
One of the common criticisms of credit derivatives is of risk and they have injected much needed liquidity
that there is substantial information asymmetry in the into the credit markets. So although we do have con-
market. In layman’s terms, this means that the large cerns, we are relatively positive about the market,” says
banks selling credit risk know more about that risk than Linnell. However, he also cautions that information

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asymmetry could hold up the development of a high-
yield credit derivatives market, if the problem is not
addressed to the satisfaction of investors.
Market players accept that there is information asym-
metry, but suggest that to focus on its existence is to
miss the real issue. “It would be strange if lenders did
not have more information than someone unconnected
with the loan, such as a credit-default swap counterpar-
ty. The real question is whether the lending bank has
This bar chart highlights the total US dollar value of
credit derivatives positions accumulated by North
American banks, divided by various product categories.
The data for this chart was compiled by Fitch and pub-
lished in a Sept. 2003 report.
appropriate controls and firewalls in place to ensure its
trading desk does not exploit that information,” says
one trader.
These concerns have been at least partly addressed by
the International Swaps and Derivatives Association
(Isda), Bond Market Association, International
Association of Credit Portfolio Managers and Loan
Syndications and Trading Association. 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 relation-
ships with a company – is not inappropriately shared
with or used by other business units or staff in the same
bank.
Bankers also point out the reputational damage that
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could be inflicted if there was even a perception that a
bank was misusing information. “Banks are fiercely
protective of their reputation and branding, particularly
in the current environment with attention focused heav-
ily in the US on legal and regulatory actions,” says the
Bank of America’s Braselton. “We, and every other
major bank, take great care to ensure our credit deriva-
tives counterparties understand the risks they are taking
on.”
Braselton adds that there is also a “major disconnect”
between perceptions about why banks enter into credit
derivatives and the genuine reasons for these trades.
“Many transactions are done on the trading book, they
are not banks hedging their own credit exposures,” he
explains.
Linnell concurs. “Only five to ten percent of loans at
major banks are typically hedged using credit deriva-
tives, so the credit derivatives market is certainly not
always about banks transferring their credit risk to
unwary investors,” he says.
Still, doubts remain about the stability of some coun-
terparties which have assumed credit risk. Fitch discov-
ered that smaller regional banks were active sellers of
This bar chart highlights the total US dollar value of
credit derivatives positions accumulated by
European/Asian banks, divided by various product cat-
egories. The data for this chart was compiled by Fitch
and published in a Sept. 2003 report.
protection, via credit derivatives. For example, the
German Landesbanks – a group of 12 regional public
sector banks – have sold roughly $19 billion of credit
protection.
While one player points out that it might make good
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risk management sense for small regional banks to write
credit derivatives to diversify their credit exposures,
some are unsure how the contracts written by
Landesbanks might be affected once these banks lose
their State guarantee in 2005. The Landesbanks are
currently guaranteed by the German government and
they therefore enjoy the highest credit ratings, making
them ideal credit-derivatives counterparties. But the rat-
ings agencies have indicated that when the State guaran-
tee expires in 2005, the Landesbanks’ ratings will fall.
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 under-
stand the severity of this counterparty concentration
problem, consider that the top 10 global banks are
involved in 70% of all credit derivatives transactions –
according to Fitch Ratings. “If one of those banks
decided to stop trading credit derivatives, the market
"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."
would immediately lose 10% to 15% of its liquidity. So
the market really needs more players to ensure its con-
tinuing health,” says Fitch’s Linnell.
What’s more, in the unlikely event that one of these
firms could not fulfill its credit derivatives obligations,
market confidence could take a huge hit, says another
market observer.
However, the credit derivatives market does not seem
to have suffered adversely from the departure of some
of the biggest insurers and reinsurers – including some
of the largest sellers of credit protection. Over the last
two years, Swiss Re, the Chubb Corporation and SCOR
Group are among the firms that have pulled out of the
credit derivatives market.
Swiss Re officials say that the firm, in early 2002,
decided to focus on the property and casualty market.
Consequently, it decided it was simply going to manage
and monitor its existing credit derivatives book until
maturity. Since it opened a credit derivatives business
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in 1997, Swiss Re’s cash loss payouts totaled just $13
million – although the firm’s 2002 annual report high-
lighted unrealized losses on credit-default swaps, on a
mark-to-market basis, of $44 million.
Meanwhile, Chubb announced in April 2003 that it
did not intend to write any more credit derivatives, but
might enter into such trades for risk management pur-
poses. And French insurance firm SCOR said in
September 2003 that it had reduced its credit deriva-
tives exposure by selling 77 names out of a portfolio of
669 – reducing its notional risk by 20% in the process.
But despite the departures of these large credit protec-
tion sellers, the credit derivatives market remains
healthy. “The fact that the market has continued to
grow, despite the exit of certain insurers, is a testament
to the growing diversity of participants using credit
derivatives,” says Sunil Hirani, chief executive officer at
Creditex, a New York-based credit derivatives broker
which runs an online trading platform.
The general feeling among market participants is that
credit derivatives present no imminent threat to the sta-
bility of the market, and regulators agree that the
instruments have played a key role in redistributing
credit risk. Market overseers 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” in the cases of Enron and WorldCom has
convinced most people in the industry that credit deriv-
atives are not a disaster waiting to happen.
Still, Linnell warns that major banking players in
credit derivatives must work harder to improve trans-
parency – via the voluntary disclosure of more informa-
tion – if they want the market to flourish. “Unless there
is greater transparency about risk transfer and who
holds what exposure, the credit derivatives market will
at some point struggle to attract new entrants,” he cau-
tions. ■
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