Balance Sheet

Credit derivatives: where will they go from here?

Margarita Michail,
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Margarita Michail, (2000) "Credit derivatives: where will they go from here?", Balance Sheet, Vol. 8 Issue: 1, pp.27-28,
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Credit derivatives: where
will they go from here?
The credit derivatives market, while being a comparatively recent development,
is growing rapidly and, as a result, it can be difficult to provide an overall assessment
of its strengths and weaknesses. Here Margarita Michail does just that, outlining the
Downloaded by UNIVERSITAS TRISAKTI, User Trisakti At 04:21 09 December 2018 (PT)
current problems and what the future may hold for the market
HE TERM ‘credit derivative’
T was probably first more widely
mentioned among dealers and
brokers in 1994. For most
people, ‘credit derivatives’ was
an abstract notion and, until that time,
only a handful of large, established banks
were involved in such transactions, which
were mostly driven by the need to cover
the exposure of their operations in
unstable countries or with unstable
counterparties.
The deals that went through were
mostly interbank and were either an
offset to a client deal, or an internal
risky position. The volume was low and
the market consisted of four to five
players (JP Morgan, Chase Manhattan,
Bank of America). It was not at all
common practice for a dealer (such as
JP Morgan) to call another bank and
inquire about a dealing market in credit
derivatives.
This market has developed slowly
during the last five years. Market
participants gradually adopted the prod-
uct as a new asset class, while its
strongest appeal was its risk manage-
ment application. In 1998 there was a
dynamic turning point for this market
with the realisation and formalisation of
the following:
■ the emergence of standardised prod-
ucts ( for example, credit default swaps,
total return swaps);
■ the initiative from the International
Swaps and Derivatives Association
(ISDA) to produce standard documen-
tation;
■ the creation of a broker market for
these products;
■ the appointment of a team to deal
and manage the product in many insti-
tutions;
■ the increased interest from major
regulatory bodies (such as the French
Commission Bancaire, the German Bun-
desaufsichtsamt fuer das Kreditwesen,
the UK’s Financial Services Authority)
and the issuance of guidelines and policy
papers.
In 1999 the market is estimated to be
at around $350 billion and continues to
develop.
Who should care about credit
derivatives?
The appeal comes from this product’s
flexibility and broad range of applica-
tions in terms of users, investment
objectives and asset classes manage-
ment.
Credit derivatives make natural
business sense for different users. Here
are a few examples:
■ Insurance companies can hedge their
commercial risks incurred in the natural
course of their business. They can also
spot investment opportunities in assets
by taking advantage of their knowledge
of the creditworthiness of issuers
required in their business.
■ Corporations can isolate and hedge
their project risks or the receivables
from counterparties.
■ Investors can tailor the maturity of
their portfolio to suit their risk appetite
by investing in a credit product
CREDIT DERIVATIVES
with shorter maturity than the
underlying asset. They can gain
exposure to certain credits that would
not be accessible in the cash market
because of illiquidity. They could
achieve principal protection.
■ Banks can better analyse and man-
age their counterparty risk resulting
from either other derivative transactions
(such as swaps) or traditional lending
functions. They can better manage their
capital, portfolios and balance sheet
items.
Flexibility is the major advantage for
investment objectives. Credit derivatives
allow an active investor to shorten his
natural exposure to certain credits;
expand his investments selection;
achieve principal protection for his
loans; and tranche his exposure by
choosing the desirable risk–return con-
figuration.
Credit derivatives can facilitate a
passive risk-taker in reducing his overall
risk; reallocating certain counterparty
risk; understanding and managing his
portfolio risk; and optimising his capital
allocation.
In terms of asset classes manage-
ment, the asset underlying a credit deriv-
ative product could be a loan, bond,
trade paper, receivables, interest rate
swaps or real estate assets.
The issuers of the underlying asset
have lower credit and could be
either sovereigns or corporates, for
example, emerging market countries,
issuers of high yield paper or distressed
issuers.
VOL 8 NO 1 | BALANCE SHEET | 27
 CREDIT DERIVATIVES
How does this work in practice?
There are various advantages the
derivatives market has to offer and some
less positive developments. An impor-
tant attraction to this market is the high
margins it offers. Dealers face at least
five basis points bid/offer spread and
brokers charge a high fee for deal
execution. In addition, market makers
can spot and take advantage of
lucrative market inefficiencies that are
inherent to new and unexplored
markets.
On the other hand, banks of differ-
ent sizes and credit ratings have entered
Downloaded by UNIVERSITAS TRISAKTI, User Trisakti At 04:21 09 December 2018 (PT)
or have plans to enter this market. Have
they set up the proper infrastructure to
receive this new team or new product ?
The answer is that it depends on the
institution.
Into which area does the newly
created credit derivatives team fit?
As mentioned above, credit derivatives
could be used by different users with dif-
ferent motivations. Organisational vari-
ables (such as structure, function and
culture) currently determine the place
and function of the credit derivatives
team in the organisation. For example,
in an investment bank the credit deriva-
tives team could fit in either of the areas
of derivatives – fixed income and credit
– and, though less obviously, it could
also fit in the areas of mortgages, merg-
ers and acquisitions, or project finance.
The proper placement of the new
credit derivatives team is not a trivial
point because it could result in bad
performance by either stretching the
derivatives team to service all areas, or
duplicating functions in overlapping
areas.
Who is in the team? Would they
get along?
Being a new asset class the credit
derivatives business consists of people
who belonged in different areas.
Typically a credit derivatives group
consists of ex-asset swap or derivatives
traders and credit people. The two
categories have different training
and business perspectives but their
input is equally important in
understanding and managing the credit
product.
28 | BALANCE SHEET | VOL 8 NO 1
The deeper problems
Regulation
Existing legislation and contract lan-
guage are currently imprecise. The
lack of clear and standard documen-
tation has slowed down the growth of
this market, causing many trades not to
be consummated because of disagree-
ments in the interpretation by the
deal’s counterparties. The regulatory
authorities have become increasingly
responsive to the need of standardised
contracts. The ISDA has published the
standardised contract for a credit default
swap.
Another area lacking clarity and
consistency is assessing regulatory capi-
tal requirements for regulated entities
such as commercial and investment
banks, insurance companies. Until now,
capital adequacy frameworks that have
been designed for other products have
been applied to credit derivatives as
well.
A milestone in addressing the inade-
quate regulation was a conference, late
last year, organised by the Bank of
England and the UK’s Financial Services
Authority. The market feels that the reg-
ulators should be in dialogue with the
market participants so that they can
produce capital rules specific to the
credit market.
Systems challenge
The modification of existing systems to
accommodate a new product or a funky
structure is always a big (and usually
costly) challenge. Credit derivatives
introduce additional complications
because:
■ The underlying asset can belong to a
range of asset classes instead of one asset
class (for example, bonds are the under-
lying asset for interest rate (IR) swaps).
■ Certain credit products require
re-creation of the projected cash flows of
the underlying asset (total return swaps).
The larger the portfolio, the more
severe the systems challenge gets.
What of the future?
Assuming that the outstanding issues of
standardised contract language and
capital reserves allocation are resolved
by the end of this year, we can safely
anticipate a healthy growth of the credit
derivatives market. An increasing
number of entrants can be observed in
this market, which accelerated in the
last year. The expected growth of this
market will manifest itself in the
following:
■ increasing liquidity in credit deriva-
tives products and the underlying
bonds;
■ increasing market depth by being
able to execute larger size tickets;
■ market widening by calling markets
in more underlying credits;
■ tighter spreads between credit swaps
and underlying bonds;
■ expansion in second and third-
generation derivative products.
As the market progresses towards
efficiency and liquidity we should
expect less variability in the pricing of
simple and exotic products. A thorough
and methodical approach can be expect-
ed in managing credit risk and possibly
a more conservative trend when
assuming risk.
An inclination towards structured
derivative products may also occur as
investors differ in their risk management
goals. Expect product specialisation by
dealers in order to meet their clients’
specific needs.
Will it fly?
The answer is ‘Yes’. Credit risk is an
old concept. The innovation is that
it is wearing a ‘derivatives suit’.
Counterparty risk is a natural, necessary
evil in conducting business. Wearing a
‘derivatives suit’ facilitates the manage-
ment and hedging of credit risk via less
costly and more flexible avenues.
Management of credit risk is a solid,
legitimate business notion which varies
in complexity depending on the organi-
sation to which it is applied.
The market’s eagerness to establish
this market properly is another strong
indicator that credit derivatives are here
to stay. ■
Margarita Michail (MBA
Finance, MS Stats and
Operations Research) is
product development
manager at Monis. Prior
to this she was trader of
IR swaps and option
books at Paribas NY.