Basics of Credit Derivatives

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Bank of England article did not criticise credit derivatives

Both Financial Times and Independent on 26th June carried stories that an article in a Bank of England's publication Financial Stability Review will criticise credit derivatives. On the other hand, the article, actually published on 28th June, was all praise for credit derivatives but for a few precautions which are only natural.

The Independent story on 26th June was titled "Bank warns of threat to global financial stability". The story said that the Bank is growing increasingly concerned about a potential threat to the global financial system from a fast-growing area of credit derivatives.

The actual article, published in Financial Stability Review, a half yearly publication of Bank of England, is here. Read it to see if it actually said credit derivatives are a threat to financial stability. Written by David Rule, G10 Financial Surveillance Division, Bank of England, the article actually says much the contrary - it says credit derivatives contribute to financial stability.

Here are a few excerpts from the article:

"Credit derivatives are one of a number of markets for the transfer of credit risk.Development of these markets has clear potential benefits for financial stability because they allow the origination and funding of credit to be separated from the efficient allocation of the resulting credit risk... ...If banks hold more diversified credit portfolios, they will be less vulnerable to idiosyncratic or sectoral asset price shocks.If they can transfer credit risk more easily,the supply of credit to borrowers will be less dependent on their willingness and ability to take credit risk,perhaps making credit crunches less likely.

"A liquid market (in credit default swaps - added for clarification) might also benefit financial stability by providing valuable price information.As market mechanisms develop to disseminate prices more widely,this has the potential to improve the allocation of credit, particularly in lending markets where history shows banks ave often failed to price risk appropriately.

Nowhere does the article talk about what the UK financial press seems to have misread. However, the article does address some possible threats, notably the fact that credit derivatives do create off-balance sheet exposures. The article says that "Continued growth of credit derivatives markets could contribute to further increases in off-balance sheet exposures amongst international banks,securities firms and potentially insurance companies.By the nature of the instruments,these exposures increase as credit risk grows within the economy,so that they may be igher during economic slowdowns." As a matter of fact, with accounting standards on derivatives having been put in place [IAS 39, FAS 133], credit derivatives are no more off-balance sheet exposures as all derivatives are required to be reported on the day they are written. The losses are also taken to income on a regular basis.

The other issue the article addresses is the high degree of concentration in the protection sellers, which is a transient issue. It is a known fact that an ever increasing number of participants are being drawn into the credit derivatives market.

Links Once again, here is the full text of the article.

ISDA members debate about impact of demerger

Credit derivatives market is bogged down not merely by legal problems such as this: disputes over market practices are even more serious. Even before the ink could dry on the restructuring supplement resolving the restructuring issue, a fresh one has erupted: the impact of demerger on credit derivative transactions.

If an obligor under a reference credit demerges, it results into creation of two entities, which, more often than not, may not have the same credit standing. As a matter of fact, number of demergers are calculated to strip the chaff from the grain. So the issue is, post demerger, which of the two, or both, of the demerged entities will form the reference credit? Usually, in demerger proceedings, the liabilities of demerging entity are divided among the resulting units based on a demerger scheme, but here, we are concerned not with the liabilities of the demerging entity, but the potential liability of the protection seller on credit events happening to the obligor. ISDA definitions provide that in a demerger case, the credit protection applies to the successor who absorbs substantial part of the entity's obligations.

This controversy was triggered when UK energy company National Power split itself into two: investment grade Innogy and below-investment-grade International Power. Market practitioners have tried to do a hair-splitting as to whether the instant case was one of demerger of spinning off. The latter is a case where the erstwhile company spins off some of its assets retaining substantial business. In National Power's case, taking the splitting view would mean the weaker company was the reference credit, with much higher probability of protection payments. On the other hand, if the substantial liability test as propounded by ISDA was followed, the successor was the healthier company. Market players contend that protection is more logically needed and given for the weaker company.

Yet another legal dispute likely over a default swap transaction

Credit derivative transactions will increasingly have to face the uncertainties and infirmities of a fledgling product. According to a report in Business Insurance Chicago Jun 4, Swiss Re Financial Products has filed a suit against XL Insurance Ltd in a court in London regarding the credit default swap transaction. This is the second legal controversy emanating from the bankruptcy of Armstrong World Industries, the US-based building materials company which went bankrupt. The first one arose between Deutsche Bank and UBS - reported here - which was later resolved by mutual, out-of-court settlement.

Swiss Re Financial Products is the protection buyer in the instant case where XL had sold protection. Pursuant to the bankruptcy of Armstrong World Industries, Swiss Re claimed protection payments, which XL has reportedly sought to decline on the ground that the swap covered only the holding company of Armstrong, and not the operating unit.

Controversies such as this had recently prompted David Clementi, Deputy Governor of Bank of England to comment against the potential risk shelters provided by credit derivatives. Obviously therefore, the market watches this development with anxious interest.

Links For an article in US Banker June 2001 talking of the uncertainties in the credit derivatives market, click here.

FSA UK issues harmonised regulatory standards for credit derivatives

Last week, the Financial Services Authority UK issued a new harmonised set of regulatory proposals called the Integrated Prudential Sourcebook which takes a new approach towards regulation of financial intermediaries. Instead of regulating various players based on the nature of their business, as insurer, banker, etc., the new regulations harmonise prudential requirements based on the risk undertaken. Obviously this approach has been necessitated by the increasing convergence taking place in the financial market. The approach "takes a risk by risk approach. It sets requirements for each of the main risks that could cause a firm major loss or insolvency: credit risk; market risk; operational risk; insurance risk; liquidity risk; and group risk".

The draft regulations are up for comment upto Dec. 31, 2001 and are slated to apply from start of 2004.

Included in the draft regulations is a set of proposals for credit derivatives, applicable for both protection buyers and protection sellers. The approach is essentially the same and the FSA has essentially aimed at harmonisation. However, the FSA does state that there are number of areas where rules have not been laid out as yet and are shortly to be laid out. These included tranched portfolio credit derivatives, transfer of portfolios with correlation, etc.

The rules are available at FSA's website at http://www.fsa.gov.uk/pubs/cp/97/index.html

Regulators concerned about robustness of credit derivatives

David Clementi, the Deputy Governor of Bank of England, makes no qualms about his disenchantment with risk transfer devices such as securitisation and credit derivatives, and regulatory rules such as Basle II which encourage the same. Recently, at a meeting of bankers in London, Clementi lamented the fact that the new Basle proposals could accentuate banking crises as they favour less risky assets to more risky assets, which could lead to bank credit drying up for companies exactly at the time when they need it the most.

Earlier this year, in a speech to Bank of Italy, Clementi made sharp observations against credit derivatives. Clementi is uncertain of the ability of such instruments to shed risk, exhibited by the uncertainties as in the case of UBS and Deutsche controversy. That dispute was later resolved, but it left scars of uncertainty. Clementi said he was concerned that spreading the risk around the banking system by use of credit derivatives meant it was no longer easy for lenders, shareholders or regulators to assess the exposure of a bank.

The Bank of England's concern also was the blurring of the distinction between banking and insurance. With many derivatives resembling insurance policies, banks needed to understand their exposure and ensure their risks were properly hedged.

Insurers turn investors in credit derivatives

This is yet another evidence of the growing convergence of insurance and non-insurance risk industry - the insurers are turning active investors in credit derivative products.

Recently, Tokio Marine and Fire Insurance Co started dealing in credit derivatives. The nonlife insurer has bought Yen 120 billion in credit risk on the debt of 100 prominent European and U.S. companies in sectors including autos and electrical equipment. The insurer has already sold off part of the credit risk to insurers and other firms in Europe and the U.S. In the year to March 2002, Tokio Marine plans to increase its exposure to credit risk by Yen 500 billion.

This is not the only instance of insurance companies looking at the credit derivatives market both for yield enhancement as also diversification into an uncorrelated risk area.

Links For an article on Investment strategies in credit default swaps, see our articles section.

Credit derivatives continue to grow
as OTC derivatives flatten

Credit derivatives continued to grow fast enough in year 2000. A peace in Financial Times of 10th May citing from a Goldman Sachs report says that the estimated notional value of credit derivatives contract at year-end 2000 stood at USD 1000 billion. Goldman Sachs expect the notional value to grow 10 times in next 5-7 years.

Vinod Kothari adds: While this is still a small portion of the overall OTC derivatives market, what is most impressive is that in the fact of a flattening growth of other OTC derivatives, the use of credit derivatives continues to grow, particularly by European banks. A BIS publication of 16th May 2001 says that the OTC derivatives market at year-end 2000 stood at USD 95.2 trillion which is just 8% higher than the volume last year.

The BIS did not collect data about credit derivatives. It however says: "Credit derivatives, which according to market sources have recently grown rapidly, are not identified in this survey. Data on such instruments will be collected at the time of the next triennial survey of foreign exchange and derivatives market activity at end-June 2001."

The Goldman Sachs report says that default swaps still form large part of the credit derivatives market at approximately 38%.

Links See also our page here.

ISDA revises restructuring definition

Restructuring as a credit event in 1999 ISDA definitions has been a bone of contention in the credit derivatives market for quite some time - see our report below. Restructuring itself is defined to include a restructuring that leads to a reduction in interest payment amounts, a reduction in principal repayment amounts, or a postponement or deferral of interest or principal payments, change in an obligation's priority, causing it to be subordinated, or any change in the currency or composition of any payment of interest or principal.

The Conseco controversy was triggered last August when the ailing insurance and finance house restructured about USD 2.8 billion of its debts by extending their maturities. With restructuring loosely defined in ISDA documentation as a credit event, this would mean compensation payments in credit default swaps will be triggered for the Conseco's lenders. The event caused fear and trepidation in credit derivatives market, as the protection sellers would be obliged to compensate for an event that is seen as routine happening in lending practice. There were larger fears of a moral hazard too, as the protection sellers feared that the protection buyers had virtually nothing to lose by agreeing to restructuring. Apart from the key question of whether or not restructuring should be a credit event, the market also found a number of unresolved issues in ISDA 1999 definitions such as how many lenders should agree to a restructuring to qualify as a credit event, what should a protection buyer deliver to the protection seller in case of a physically-settled credit swap.

In early April this year, after prolonged discussions, ISDA amended the 1999 definitions with a new supplement that brought about refinements in definition of "restructuring. The crux of the amendments is to specify that a loan that would qualify for restructuring must have multiple lenders (at least 3), and least 2/3rds of the lenders must agree to restructuring. Besides, the protection buyer must deliver instruments maturing not later than 30 months from the date of restructuring.

Thomson Financial invests in Creditex

Thomson Financial Ventures, the venture capital arm of Canada-based Thomson Financial, has invested in undisclosed amount in the capital of Creditex, an automated credit derivatives trading platform. This investment brings the total raised by New York-based creditex to more than $25 million, according to co-founder Sunil Hirani.

Creditex reportedly has received registrations from 85 market players and claims to conclude transactions in real time.

 

UBS sues Deutsche Bank for derivatives default

Swiss bank UBS AG has sued Deutsche Bank AG for more than USD 10 million, according to documents filed with Britain's High Court of Justice. They show UBS is alleging Deutsche is in default in a credit derivative deal designed to pay if U.S. building materials maker Armstrong World Industries Inc defaulted on its debt.

UBS has apparently written a credit default swap transaction with Deutsche Bank for bonds of Armstrong, due in 2005. Armstrong has, in the meantime, restructured its corporate structure and transferred ownership of its stock to its holding company. The holding company has filed under Chapter 11 for protection. Under standard definitions of credit derivatives, such a restructuring is a credit event, and should come for payment by the protection seller.

The parties have possibly a legal duel on the technical wording of the swap agreement.

Bank loan securitisation market riding piggy-back on credit derivatives

Ever since their appearance in 1996, credit derivatives have followed rather than faced economic downturns. Their popularity increased tremendously with the Asian currency crisis, Latin American crisis etc. But in the past, credit derivati

Trying times ahead for credit derivatives

Ever since their appearance in 1996, credit derivatives have followed rather than faced economic downturns. Their popularity increased tremendously with the Asian currency crisis, Latin American crisis etc. But in the past, credit derivatives have not been put to the acid test of an economic recession. Now that the US economy seems preparing for a tough time, credit derivatives may face the real trial for the first time.

According to a report by Moody's, rating downgrades have exceeded rating upgrades by the largest margin ever since 1991. Banks that kept lending liberally to yesterday's investment grade corporates now find the ratings of their clients being downgraded. And the risk of such downgrade might have already been hived off by the bank through derivatives.

A report in Financial Times 16th Jan says: "troubling questions remain. Bad loans began creeping up last year, before the US economy began losing steam. That suggests that banks are ill prepared for recession. Just as serious, the banks' use of credit derivatives and other forms of protection against ruin have yet to be tested in a serious downturn. Credit derivatives are only as robust as the counterparty in the trade. The financial system may be about to enter uncharted territory."

 

Leading consulting firms join for CreditDimensions.com

Ten leading participants in the credit risk arena recently announced an initiative to form an online community. CreditDimensions will be the first online credit community to offer financial institutions the full spectrum of integrated credit risk management services within a single web site. Algorithmics, Bureau van Dijk Electronic Publishing (BvD), Credit Suisse First Boston, Cygnifi, eCredit.com, Gifford Fong Associates, KMV, PricewaterhouseCoopers, RiskMetrics and Standard & Poor's will provide site content.

PricewaterhouseCoopers is designing and developing the system and network architecture for CreditDimensions. Cisco Systems, Inc. is contributing its expertise in infrastructure design and network security.

CreditDimensions will offer subscribers an efficient and effective means to implement credit risk management processes using the following tools:

- Credit risk analytic models
- Credit and market data
- Counterparty static data, including organization hierarchies
- Credit analysis process tools
- Credit-related news and research

New instruments of risk transfer
to drive growth in 2001

Analysts expect year 2001 to register far faster growth in the fledgling credit derivative markets, and the growth will come mainly from the new instruments of risk transfer such as synthetic securitisations.

While bulk of credit derivatives market is still composed of the traditional credit default swap, thge use of synthetic securitisations is growing. Evidence is available in the data for 2000 (to date) asset-backed securities issued. Of the total non-US asset-backed issuance of USD 80.49 billion, synthetic securities comprised of USD 34.533 billion, says a report on Reuters 20th Dec., quoting Merril Lynch.

Credit derivative market turns
jittery as Conseco restructures debt

Simon Boughey writing in the Investment Dealers' Digest would call it a chaos in the credit derivative market: leading players are seeking to redefine the credit events based on which payments are triggered under a credit default swap, so as to exclude restructuring. Reason: demand for payments due to a restructuring done by Conseco Finance. Conseco Finance, the US-based consumer finance company, was recently put under the control of the legendary financial wizard Gary Wendt who caused restructuring of more than USD 3 billion in the debt owing by the company.

What are triggers under ISDA

The International Swaps Dealers Association (ISDA) in January 1998 formed a concordat under which the following events were defined as trigger events. These are: bankruptcy; a credit deterioration that happens in the event of a merger; cross acceleration; a cross default; a downgrade; failure to pay; repudiation and restructuring.

Restructuring is one of the events based on which payments under a credit default swap are triggered. The report by Simon Boughey says that this has resulted into a peculiar situation where the top market makers in credit derivatives refuse to acknowledge restructuring as a trigger event, and where they do, they demand a differential price. As a result, a two-tier system in the U.S. has emerged, with different prices being quoted in London. The result is a decline in liquidity and mass confusion all around. Market practitioners complain that over the past of couple of months or so, ISDA has tried to resolve the difficulty created by the Conseco case, but these meetings have only compounded the chaos.

 

Provident Financial to use credit derivatives to shift credit risk

Cincinnati, US -based banking company Provident Financial Group will try to resolve higher capital requirements by transferring some of its credit risk to third-party investors, using credit derivatives. The company would shift exposure to subprime loans by USD 100 million, possibly using a synthetic securitisation device that was used in Europe or by JP Morgan in USA or what Fannie Mae has used. The European synthetic securitisation, it is notable, had used a combination of securtisation and credit derivatives in a transaction labeled Sequils - click here to know more about this deal.

J.P. Morgan has been issuing credit derivatives through its Broad Index Secured Trust Offering program, or Bistro, since December 1997, when it offloaded the risk on a $9.7 billion corporate loan portfolio. In the simplest Bistro deals, a trust sells bonds and uses the proceeds to buy Treasury securities, which sit in the trust. J.P. Morgan pays a fee to the trust, which pays bondholders an extra spread over the yield on the Treasuries, to compensate for the risk they are taking on. If the loans become delinquent or default, the trust pays Morgan, and investors' return is reduced or eliminated.

Two years ago Freddie Mac issued bonds called Mortgage Default Recourse Notes, or Moderns, which were linked to the performance of $20 billion of mortgages

Provident Financial is concerned about the recent regulatory move by US financial regulators to increase capital requirements in case of riskier segments of securitisation transactions. The risk transfer by a proposed credit derivative transaction would help Provident comply with the proposed tough capital rule.

British Bankers Association lauds 9 fold increase in credit derivatives volume over 5 years

British Bankers Association recently [Press release of 20th July, 2000] made refined estimate of the market size of credit derivatives and made some predictions for the volumes in future.

The Association said that global market estimates indicate that the credit derivatives market reached USD 586 billion at the end of 1999 and is expected to jump to USD893 billion by the end of 2000, reaching USD1581 billion by the year 2002. Based on previous BBA surveys this represents a 9-fold increase in the 5-year period 1997 to 2002. The BBA had in Sept., 1998 predicted that credit derivatives global volumes will be at about USD 740 billion by end-2000. It must, therefore, be happy to note that the market is exceeding its predictions.

The market in London is doing very well. Estimates by the Association indicate that the London market stood at $272 billion for 1999, $417 billion for 2000 and $741 for 2002.

Almost half of global derivatives are traded in London, a figure predicted to remain constant in 2002.

Read this with the report on US volumes - see news below.

Links: Also see news report below. See more market reports on our Market section.

Internet Capital Group acquires stake in Credittrade.com

Internet Capital Group, a B2B e-commerce company, has acquired an interest in CreditTrade.com, a trading platform for credit derivatives, for approximately $7.4 million. Internet Capital Group regards credit derivatives and syndicated loans as two of the fastest growing segments of financial derivatives marketplace.

According to Internet Capital Group, the credit derivatives market is escalating as more institutions are actively trading and managing risk in their credit and loan portfolios. The credit derivatives market has grown from $40 billion outstanding notional value in 1996 to an estimated $740 billion by the end of 2000, according to forecasts from the British Bankers' Association. Despite 100% growth rate predictions for the near-term, the markets still suffer from numerous inefficiencies such as lack of pricing and information transparency, lack of consensus in pricing methodology and high transaction costs.

CreditTrade.com is the world's first online business to business financial exchange set up to allow wholesale counter parties to trade credit through the Internet. CreditTrade uses a powerful server facility connected directly to the Internet backbone via multiple redundant high-speed lines to provide a simple, efficient mechanism for buyers and sellers of non-commoditized credit risk to meet and negotiate deals.

German bank places mega credit default swap

German bank COMMERZBANK recently launched its mega mortgage-backed synthetic securitization transaction containing a combination of a credit default swap and a floating rate note. The transaction did not use an SPV.

The deal, totaling in size Eu 2.5 billion of mortgages, contained a credit default swap of Eu1.5bn which was placed as a super-senior credit default swap with an OECD bank. The balance was sold as Eu 1 billion of floating rate notes.

Commerz became one of the first banks in the world to use synthetic technology for mortgage-backed transactions, with a fully unfunded deal.

Investors flock to credit derivatives for spreads

Financial Times recently [28th June, 2000] published a supplement on derivatives. A comment on increasing popularity of credit derivatives says that investors are using credit derivatives in form of credit linked notes to obtain high yields and equity-like returns.. Typical yields could go as high as 4-5 per cent over Libor but, depending on the risk appetite of the investors, returns can range from a small margin over Libor for unleveraged good quality paper to as much as a 20 per cent flat yield. By trading credit default spreads around so-called credit events, for instance a change in government, or a corporate restructuring, equity market style profits can be made.

The major investors in credit derivatives are hedge funds, insurance companies and asset managers.

Of late, the biggest source of supply in the market is synthetic CLOs [for more on synthetic CLOs, click on our securitization site for a page on bank loans securitization] whereby banks can shed large bulks of their balance sheet credit. This page was recently updated to include more details on synthetic CLOs.

JP Morgan to launch credit derivatives index on 28th June

This may be a milestone in the history of development of the credit derivative market. J.P. Morgan will be launching on Wednesday 28th June the first index based on credit derivatives.

The index aims to rectify the structural weakness of the euro-zone credit market which is dominated by highly rated banks and financial institutions, rather than lower-rated industrial companies as it is in the US. Banks and financial institutions account for more than two-thirds of the euro-zone bond market. The composition of J.P. Morgan's index will be two-thirds non-bank, with average ratings of A/AA-.

The index, called the European Credit Swap index, is based on the fledgling class of credit derivatives that allow investors to isolate the credit risk of a company and then trade it with other parties. Instead of buying a bond from an issuer, an investor sells credit protection on the issuer to a third party, a bank for example, and thereby takes on a risk of a company defaulting.

About 2 months ago, JP Morgan had set up an electronic trading platform for credit derivatives - click for the news item and link to JP Morgan website here.

Swiss company launches synthetic securitization

Swiss company UBS AG is to launch a synthetic securitisation transaction called Helvetic Asset Trust, which securitises part of the risks attached to Swiss corporate loans and turns them into tradable instruments. UBS will securitise part of the credit risks attached to a SFR 2.5 bln portfolio of loans to Swiss small and medium-sized enterprises.

It is the first transaction in the domestic capital market involving the transfer to the capital market not of the credit itself, but of the loan loss risks alone.

Notes Synthetic securitization is a kind of a credit derivative that combines financing with transfer of credit risks.Generally carried in form of credit linked notes, the investors in such notes agree on a compensation to the originator should specified credit events take place. For more on securitization, click on Vinod Kothari's Securitization site - click here.

Credit derivatives on steep growth curve - article

Credit derivatives are on a steep and relentless growth curve, says Daniel Keeler in an article in Global Finance March 2000. This is against the backdrop of an unsettled derivative market in general, since Asian and Russian crises of 1997 and 1999. The author quotes British Bankers Association to estimate the worldwide credit derivatives market at a volume of USD 740 billion by end-2000, an increase of almost 300% in just three years.The London market alone will be worth around $380 billion, a figure that is twice the total global outstanding credit derivatives at the end of 1997. Looking at the overall interest rate and exchange rate derivatives market, these volumes are "like a drop in the ocean", but what matters is the trend.

"Once viewed with some suspicion by many investors, credit derivatives are now receiving high-profile support from banking authorities", says the author.

The overriding impact of the development of the credit derivatives market is that the gap between broader capital markets and the traditional credit market is beginning to be bridged. Investors and financial institutions are gaining access to credit markets and products that were previously unavailable, and both groups are now able to manage their credit risk more effectively. "As long as there is demand for diversified risk, it is likely the credit derivatives market will continue to expand at a dramatic rate", predicts the author.

The article also gives data about UK credit derivative market.

US credit derivative volumes grow 5.2% in Q1,2000

US credit derivative volumes grew 5.2% in first quarter of 2000 to grow to an outstanding notional value of USD 302 billion, says American Banker 7th June, 2000 quoting a senior official in the Office of Comptroller of Currency. Mike Brosnan, Deputy Comptroller of Risk Evaluation was optimistic that in time to come banks will make more money on newer products such as credit derivatives.

Also see a report below on European volumes.

The end-1999 data about credit derivatives in the USA was USD 287 billion, jumping up by USD 53 billion.

Links: For more on credir derivatives in USA, click on our country page on USA - click here.

Credit derivatives fastest growing derivatives

A write up in Financial Times 19th May 2000 by Clare Smith says that credit derivatives are the fastest growing sector of the global derivatives market. The estimated value of notional amounts of credit derivative contracts outstanding at the end 2000 is expected to be USD 800bn, more than double the figure at the end 1998, and well beyond expectations in 1995 when the market was initiated.

According to the write up, there are two significant developments that have recently expanded the credit derivative market: entry of non-bank participants and electronic trading.

To begin with, credit derivative market was essentially an inter-bank market but today, "end-users such as commercial banks managing loan books, insurance companies, hedge funds and corporates have entered the fray", says the write-up.

Electronic trading platforms are another recent feature - JP Morgan and Creditex have launched automated exchanges for credit derivatives - see news reports on this site here and here.

The largest share of credit derivative market is still taken by credit default swap transactions, where the protection buyer pays credit risk premium to the protection seller on a notional amount of protection received against credit defaults, in which case the seller will be obliged to pay compensation to the buyer. [For more on types of credit derivatives, see the primer on this site - click here.] The write up says that 3/4ths of the total credit derivative market still consists of credit default swaps.

The report while talking about market developments affirms that currently, Europe accounts for a larger share (approx 31%) of the credit derivative market than the US (approx. 27%). Also see here another report on US volumes - click here.

"Credit derivatives are primarily used for transfer and transformation of risk. Banks can lay off risk in the market and continue to lend to important relationships, when in the past they would be nearing limits. Significant increases in the efficiency of capital management can be obtained. For instance, JP Morgan have used credit derivatives on Dollars 40bn of assets to cut economic capital usage in credit portfolios by half. Banks can add, decrease or adjust credit exposure without necessarily having any underlying relationship with the company," says the author.

Credit derivatives have increased acceptability
says Standard and Poor's

In a recent report [Structured Finance April 2000] rating agency Standard and Poor's says credit derivatives have found increased acceptability. "Not only is there growing market acceptance of credit derivatives, their applications in securitizations are also expanding. Many financial institutions are developing innovative structures by applying credit derivatives to a variety of asset types, such as emerging market debt, project financings, and small business loans", says the report.

JP Morgan creates derivatives trading platform

JP Morgan on 26th April reported starting of a website [www.morgancredit.com] for trading in credit derivatives. According to a company press release, the site is the first to offer live two-way (bid and offer) credit derivative prices on hundreds of North American, European and Asian credits and the ability to trade these over telephone links to trading desks. In addition, the site will create the first transparent forward curve for credit risk by featuring two-way prices for three-, five-, seven- and ten-year maturities.

The company release claims that the site also contains a library of relevant research marterial. [Vinod Kothari comments: When I tried to access the site, I was required to log in with a password, and there was no way indicated as to how I could obtain one].

The site maintains an advantage over broker sites. Because J.P. Morgan is acting as principal, it eliminates the intermediary step of matching client trades, protecting client anonymity and significantly reducing the time to close a transaction.

Electronic trading platform for credit derivatives

A group of credit derivative professionals has launched an exclusive electronic trading platform for credit derivatives. Founded by Sunil Hirani and John McEvoy, Creditex is not only a trading platform but also a rich resource base for credit derivatives. Click here to access Creditex.

Creditex investors include J.P. Morgan, Morgan Stanley Dean Witter, Capital Reinsurance Company and Pacific Life Insurance Company. In addition to creating a negotiations platform for its qualified participants, creditex will also provide documentation, historical data and related information to help parties and counterparties find one another and execute their deals. The company runs an overseas office in London.

 

Corporate sector embracing credit derivatives

A report in Financial Times 9th March says credit derivatives are no longer the domain of bankers but are finding acceptability even by the corporate sector. The largest segment in the credit derivatives market - credit default swaps, is beginning to get demystified and have appeal for corporate investors as well. Europe is unarguably more active market for credit default swaps than the US.

"The growth of the corporate bond market in Europe has given credit default swaps a starring role. The heady pace of European M&A activity has often harmed the credit quality of the companies involved, and has led to a higher number of rating downgrades", says the report. Credit swaps also allow investors to speculate on movements in the credit market, as they focus solely on a company's credit quality. The product removes the influence of movements in interest rates, swap spreads and currencies, the factors most commonly affecting values in the bond market.

Several factors have moved the market forward and increased its accessibility to a wider pool of investors. Recently, an electronic trading platform for credit derivatives, viz., Creditex, was formed recently - see news report on this site. Creditex hopes to enhance the transparency and liquidity of the market by making trading easier and providing a database of market information. Besides, J.P. Morgan launched an index for credit default swaps in Europe, called the European Credit Swap Index (ESCI), containing 98 leading corporate names from the Eurotop 100 and the Eurostoxx 50.