Growth in Credit Derivatives Begins Attracting the Attention Of Policymakers, Regulators

Global Finance, Oct 2005 by Platt, Gordon

CORPORATE FINANCING FOCUS

The Federal Reserve Bank of New York invited 14 major participants in the credit-derivatives market, primarily investment banks, to a meeting on September 15 to discuss market practices in the fast-growing industry.

Credit derivatives, which are linked to the probability that a company will pay its debts and which have become popular hedge-fund investments, have been growing so quickly that regulators worldwide have expressed concerns about delays and errors in processing trades. Hedge funds are so big and do so much trading that they have changed the dynamics of the corporate bond market. These sometimes highly leveraged funds are the biggest users of credit derivatives.

There were $8.4 trillion of credit default swaps outstanding at the end of 2004, a nine-fold increase in just three years, according to the International Swaps and Derivatives Association, or ISDA, the global trade association of the privately negotiated derivatives industry. A credit default swap is an agreement by one party to accept a premium at regular intervals in return for making a larger payment if a specific company defaults, goes bankrupt or suffers a negative credit event.

Price swings in the credit derivatives market following the downgrades of Ford Motor and General Motors debt in May caused hedge funds to lose between $1 billion and $2 billion and raised fears of a -wider financial meltdown, similar to the collapse of Long-Term Capital Management in 1.998. While that didn't happen this time, the New York Fed wants to help make sure it won't have to launch more rescue missions.

Representatives from the US securities and Exchange Commission, the Office of the Comptroller of the Currency, the New York State Banking Department, the UK's Financial Services Authority, Germany's Federal Financial Supervisory Authority and the Swiss Federal Banking Commission also were invited to attend the New York meeting. Despite the presence of so many financial supervisors at the gathering, industry participants say regulatory and legislative restrictions on over-the-counter derivatives are unnecessary and are unlikely to be imposed.

Andrew P. Cross, associate and member of the investment management group at international law firm Reed Smiths Pittsburgh, Pennsylvania, office, says the sharp growth in the credit derivatives market, and in over-the-counter derivatives in general, has been very exciting. "A key success factor will be controlled and sustainable growth," Cross says. "While the industry has embarked on a new journey, the over-the-counter derivatives market is not an unmanned ship. Very skilled and qualified leaders are looking out at the horizon and guiding the industry," he says.

One reason the growth has been so rapid is because there has been thoughtfulness on the part of market participants, through participation in industry groups such as ISDA, according to Cross. He commends the New York Fed and the Counterparty Risk Management Policy Group, or CRMPG, chaired by E. Gerald Corrigan, managing director in the office of the chairman at Goldman Sachs, for acting in a pro-active manner. The CRMPG, which includes senior officials from financial institutions, recommended the September 15 meeting to address certain documentation issues before they got to the point of becoming a problem, Cross says.

In a report released on July 27, the Corrigan-led group examined the challenges faced by market participants with regard to the management and use of highly complex financial instruments. "The deals can get complicated, but they are able to be understood," Cross says.

Market Depth Untested

Andrew Large, deputy governor of the Bank of England, warned in a speech on May 18, following turbulence in the market caused by the downgrade of GM and Ford Motor debt, that credit derivatives could add to the risk of instability in financial markets. "Credit risk transfer has introduced new holders of credit risk, such as hedge funds and insurance companies, at a time when market depth is untested," Large told an international conference of financial regulators in Turkey. About two-thirds of the trading in the credit derivatives market takes place in London.

The British central banker's remarks followed a similar warning by Federal Reserve chairman Alan Greenspan on May 5. "The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress," according to Greenspan, who described credit derivatives as the most significant development in financial markets over the past 10 years. "A sudden widening of credit spreads could result in unanticipated losses to investors in some of the newer, more complex structured credit products, and those investors could include some leveraged hedge funds," the Fed chief said.

The CRMPG said in its July 27 report that the financial services industry has very limited experience with settling very large numbers of transactions following a credit event, such as a major corporate default.