Abstract
This paper reviews prevailing credit derivatives markets regulation and comments on the need to regulate these markets in light of the recent financial crisis. Although credit derivatives may have beneficial effects such as enhancing the resilience of the financial system, these benefits can only be reaped if credit derivatives are used prudently and responsibly by all market participants. We argue that the current regulatory regime is not sufficient to induce market participants to use credit derivatives in a desirable way. Rather, the existing system, which is mainly based on self-regulatory initiatives, should be accompanied by supervisory action such as the introduction of mandatory disclosure of credit derivative transactions or collateral requirements for all credit derivative transaction counterparties. The combination of self-regulatory initiatives together with strict supervisory action seems to be well suited to help in preventing market participants from misusing credit derivatives, therewith dampening the dangers these instruments might pose to the stability of the financial system.
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REFERENCES AND NOTES
British Bankers Association. (2006) Credit Derivatives Report 2006. London, September.
Bank for International Settlement. (2008) OTC Derivatives Market Activity in the First Half of 2008. Basel, November.
CLN are designed to enable investors to capture returns on a single reference entity (an underlying bond or loan).
Credit spread products are options or forwards on the credit spread of bonds, loans or other credit risk-related assets. These instruments allow the separate trading of the credit spread for the purpose of risk reduction, speculation or return enhancement.
CDO is the generic term used for credit portfolio securitisation. It entails repackaging credit portfolios (loans/bonds and/or derivatives) for sale to investors. Thus, a CDO can be described as a combination of a fixed income security with an embedded credit derivative.
In March 2003, the Financial Times quoted Warren Buffett with the following: ‘Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal to the financial system’. In a letter to the shareholders of his company Berkshire Hathaway, Inc., he added that ‘derivatives are wildly mis-priced, but continue to generate hundreds of millions of dollars’. This quote nicely reflects the fear of (some) market participants and observers that credit derivatives may threaten the stability of the financial system.
The CDS was invented in the mid-1990s by a young Cambridge University mathematics graduate, Blythe Masters, who was then hired by J.P. Morgan Chase Bank in New York. This new instrument provided a revolutionary new risk management (and speculation) tool for global credit markets.
Although the market volume figures vary between the available sources (BBA, BIS, Fitch, ISDA) they all show the same trend of a continuing rapid growth. The variation owes to the fact that most stylised facts stem from surveys and survey participants may vary from source to source.
FitchRatings. (2007) Market Volumes Continue Growing While New Concerns Emerge. New York. Special Report, July.
FitchRatings. (2006) Global Credit Derivatives Survey: Indices Dominate Growth as Banks’ Risk Position Shifts. New York. Special Report, September.
This section draws on Rule (2001) The Credit Derivatives Market: Its Development and Possible Implications for Financial Stability. London. Bank of England, Financial Stability Review, June.
Das, S. (2005) Credit Derivatives, CDO and Structured Credit Products, 3rd edn. Singapore: Wiley Finance.
Mengle, D. (2007) Credit Derivatives: An Overview. ISDA, 2007 Financial Markets Conference, Federal Reserve Bank of Atlanta, 15 May, Atlanta.
According to the BIS, replacement cost risk is the risk that a default of a counterparty will require the non-defaulting counterparty to incur a cost to replace the contract or a portfolio of contracts. See Bank for International Settlement. (1998) OTC Derivatives: Settlement Procedures and Counterparty Risk Management. Basel. Report prepared by the Committee on Payment and Settlement Systems and the Euro-currency Standing Committee of the central banks of the Group of Ten countries, September.
A synthetic securitisation is a structured transaction that involves the transfer of risk on a portfolio of assets through a CDS or CLN. The originating bank packages more than 10 reference loan entities into a portfolio product. The package is subsequently sold to an independent SPV formed for the specific purpose of funding the loans. The SPV is a separate company and must not be owned by the originator. In a classical or cash securitisation transaction, the SPV issues tradable securities to fund its purchase of the loan portfolio from the originator. The performance of these securities is directly linked to the performance of the loan portfolio. The securities are then sold to investors. In a synthetic securitisation transaction, a CDS on the reference portfolio is created between the originating bank and the SPV. The originating bank pays a premium to the SPV and in case of a credit event the SPV ensures the default payment to the originating bank.
The characteristics of this transaction type are the following: (a) only credit risk is transferred, (b) assets remain on the balance sheet, (c) there is no generated funding.
See Note13
The equity tranche usually remains with the originating bank as a signaling device. However, it appears that in recent years the originators often also sold the equity tranche. This might be very problematic because it can reduce the originator's incentives to monitor the underlying reference entity, which could increase the risk of the reference entity. This, in turn, might increase the risk of all issued tranches. Some researchers argue that this was one of the main reasons that caused the recent breakdown of the CDO market with the known consequences.
See Franke, G. and Krahnen, J. P. (2008) The Future of Securitization. Frankfurt. Center for Financial Studies Working Paper no. 2008/31.
CDX is a brand name for the family of CDS index products covering North America and emerging markets. They are owned, managed, compiled and published by Markit Group Limited, the leading industry source of independent pricing, reference data and valuations.
iTraxx is the brand name for the family of CDS index products covering European and Asian markets. These indices were launched in 2004 in conjunction with a consortium of leading global investment banks. The rules-based indices comprise the most liquid entities in the European and Asian credit markets, and consist of iTraxx Europe, iTraxx Hivol, iTraxx Crossover, iTraxx Asia ex-Japan, iTraxx Japan, iTraxx Australia, iTraxx SDI-75 and various sub-indices. The iTraxx indices were owned, managed, compiled and published by International Index Company (IIC), a leading independent provider of credit derivative and fixed income indices that also licenses market makers. In April 2006, IIC and Markit announced that they had signed an agreement governing the calculation and publication of IIC's iTraxx indices, the benchmark for the European and Asian credit markets.
After the government had to inject several billions of Euros into IKB Bank, it was eventually sold to Lonestar, Landesbank Sachsen, on the other hand, was taken over by another state-owned German bank, Landesbank Baden-Württemberg.
Leading market participants recognised the need for documentation standardisation and worked with the ISDA to develop a standard documentation format for CDS, the so-called ‘ISDA Master Agreement’. The first attempt to standardise documentation resulted in the development of the confirmation for an OTC credit default swap transaction (single reference entity, non sovereign). This confirmation entitled the Long Form Documentation was published in 1998. However, the structure of this document was very complex and caused delays and misunderstandings among market participants. It therewith increased the risk of operational errors. In July 1999, the ISDA published a revised standard documentary framework for privately negotiated CDS. The revised format consisted of (a) a standard definition for CDS (The 1999 Definition); and (b) a shorter confirmation for individual CDS, the so-called short form confirmation. In 2002, the ISDA reviewed the 1999 credit derivatives definitions, and in February 2003 it adopted a new set of definitions.
Bank for International Settlement. (2003) Credit Risk Transfer. Basel. Report prepared by the Committee on the Global Financial System, January.
See European Central Bank. (2004) Credit Risk Transfer by EU Banks: Activities, Risks and Risk Management. Frankfurt, May.
Durbin, M. P. (2006) All About Derivatives. New York: McGraw-Hill.
We will henceforth use the terms CRT transaction and credit derivative transaction interchangeably as credit risk is usually transferred by means of a credit derivative transaction.
FitchRatings. (2004) Global Credit Derivatives Survey: Single-Name CDS Fuel Growth. New York. Special Report, September.
FitchRatings. (2005) Global Credit Derivatives Survey: Risk Dispersion Accelerates. New York. Special Report, November.
Diamond first pointed out that banks may act as delegated monitors. See Diamond, D. (1984) Financial intermediation and delegated monitoring. Review of Economic Studies 51: 393–414.
Morrison, A. D. (2005) Credit derivatives, disintermediation and investment decisions. Journal of Business 78: 621–647.
How a reduction in banks’ monitoring effort may have affected the market for structured securities and exacerbated the financial crisis as well as possible remedies are discussed in detail in19
Gorton, G. B. and Pennacchi, G. (1995) Banks and loan sales: Marketing nonmarketable assets. Journal of Monetary Economics 35: 389–411.
DeMarzo, P. and Duffie, D. (1999) A liquidity-based model of security design. Econometrica 67 (1): 65–99.
Duffee, G. R. and Zhou, C. (2001) Credit derivatives in banking: Useful tools for managing risk? Journal of Monetary Economics 48: 25–54.
Arping, S. (2005) Credit Protection and Lending Relationships. University of Amsterdam. Working Paper.
Marsh, I. and Wagner, W. (2006) Credit risk transfer and financial sector stability. Journal of Financial Stability 2: 173–193.
Chiesa, G. (2006) Risk Transfer, Lending Capacity, and Real Investment Activity. University of Bologna. Working Paper.
Duffie, D. (2007) Innovations in Credit Risk Transfer: Implications for Financial Stability. Stanford University. Working Pape.
Franke, G. and Krahnen, J. P. (2007) Default risk sharing between banks and markets: The case of collateralized debt obligation. In: M. Carey and R. Stulz (eds.) Risks of Financial Institutions, National Bureau of Economic Research. Chicago: Chicago University Press, pp. 603–634.
International Monetary Fund. (2006) The Influence of Credit Derivative and Structured Credit Markets on Financial Stability. Washington. Global Financial Stability Report, Chapter II, April.
For instance, the premia for CDS are nowadays an important indicator of a firm's or a bank's credit quality.
A discussion of the information content of CDS index tranches for financial stability is provided in European Central Bank. (2006) Financial Stability Review. Frankfurt, December.
But, as the IMF points out: ‘However, once transferred, secondary market liquidity risks remain, and may constitute the most significant stability risk emanating from the structured credit markets’. See41, p. 66.
Through a traditional fully funded CLN.
Through synthetic securitisation, for instance.
However, Wagner (2007) showed that the benefits of increased liquidity through risk transfers in good times and enhanced power of liquidation in a crisis are counterbalanced by hefty increases in banks’ risk taking. Overall, stability is reduced because the enhanced liquidation in a crisis reduces banks’ incentives to avoid a crisis. Banks therefore take on an amount of new risk that leads to a higher probability of default. See Wagner, W. (2007) The liquidity of bank assets and banking stability. Journal of Banking & Finance 31: 121–139.
As pointed out in Duffie: ‘Even specialists in collateralized debt obligations (CDOs) are currently ill equipped to measure the risks and fair valuation of tranches that are sensitive to default correlation. This is currently the weakest link in CRT markets, which could suffer a dramatic loss of liquidity in the event of a sudden failure of a large specialty investor or a surprise cluster of corporate defaults’. See39, p. 4.
A discussion on the US subprime mortgage loan problems spillover to CRT markets is provided in European Central Bank. (2007) Financial Stability Review. Frankfurt, June.
These securities may include risky CDO tranches. Such assets can be particularly illiquid and vulnerable to macroeconomic performance and may be used as an argument against CRT by banks.
For instance, the bail outs of Bearn Sterns and AIG, and the bankruptcy of Lehman Brothers which fueled a wave of banking bail outs and bank losses across the globe.
A vivid example is the almost collapse of the German IKB Bank which suffered heavy losses because of the US subprime crisis. Only with the help of the mostly governmentally owned Kreditanstalt für Wiederaufbau and some other public and private German banks, which together injected more than 8 billion Euro into IKB, could the collapse be averted. IKB Bank was later on sold to Lonestar for a price of roughly 100 million Euro.
On 13 September, Northern Rock actually experienced a bank run ‘obliging’ the UK Government to intervene by safeguarding depositors and changing the previous stance about the adverse impact (increasing moral hazard and sowing seeds for future financial crisis) of bailing out risky behaviours of aggressive lenders.
The collapse of the Icelandic Landsbanki in October 2008, along with several other difficulties affecting the country's banking institutions and the incapacity of the government to ensure a credible bail out have undermined the creditworthiness of Iceland as a country. Some other countries like Hungary and Pakistan also faced severe problems and had to be ‘saved’ with money from the IMF.
Figure taken from Hedge funds research, Inc., available at www.hedgefundresearch.com, accessed 10 May 2008.
An industry-led initiative to regulate hedge funds is underway. A hedge fund working group headed by Andrew Large, former deputy governor of the Bank of England, will look at existing principles, standards and guidelines, will evaluate areas that may require strengthening, and will suggest applicable solutions that may include voluntary adherence to voluntary standards.
Bank for International Settlement. (2005) Credit Risk Transfer. Basel, March.
Bank for International Settlement. (2005) The Application of Basel II to Trading Activities and Treatment of Double Default. Basel, July.
There are two basic ways to determine a CDS spread, namely, from asset swap spreads and from the calculation of expected CDS cash flows.
Another reason why rating might have ‘failed’ to properly assess the credit risk of the complex structured products is that they were working closely together with the originators. At the same time at which they were supposed to rate the issues, they were consulting the originators on how to structure the issue in order to receive a certain rating. This created room for moral hazard behaviour on the side of the rating agencies and should doubtlessly be forbidden in the future.
Miller, M. (1986) Financial innovation: The last twenty years and the next. Journal of Financial and Quantitative Analysis 21: 459–471.
See Miller, M.H. and Miller, A. (1991) Financial Innovations and Market Volatility. Cambridge, MA: Blackwell Publishers.
Bergman, W. J., Bliss, R. R., Johnson, C. A. and Kaufman, G. G. (2004) Netting, financial contracts, and banks: The economic implications. In: G. Kaufman (ed.) Market Discipline in Banking: Theory and Evidence, Vol. 15 of Research in Financial Services, Amsterdam: Elsevier Press, pp. 303–334.
On 17 August 1998, the Russian government announced the restructuring of its sovereign bond debt and suspended payments on those securities. In response to this announcement, the foreign currency-denominated external debt depreciated strongly, in spite of the fact that it had not been ascertained that Russia would also default on this asset class. The diverse nature of Russia's debt highlighted the gaps in the existing documentation covering CDS contracts. The complex structure of Russia's debt and the litigation arising from it prompted the ISDA to tighten up certain aspects of their documentation. More specific details were included regarding the issuer's identity, subordination clauses and creditor's status.
Following the moratorium on Argentina's external debt declared on 23 December 2001, the settlement of CDS contracts did not encounter many difficulties given that at mid-February 2002, 95 per cent of outstanding CDS contracts had been settled. Nonetheless, the settlement of CDS in this context provided an opportunity to define contracts more precisely with regard to three main aspects: (1) Definition of a credit event: debt swaps executed on a voluntary basis were no longer considered as credit events. Protection buyers wanted to include the exchange of debt that had taken place in November 2001 in the moratorium, arguing that it constituted a restructuring linked to the default. (2) Definition of deliverables: zero-coupon bonds that satisfy the criterion of non-contingence were accepted as deliverables. (3) Option of partial cash settlement: partial cash settlement was permitted in case that the protection buyer is unable, either out of technical or legal reasons, to deliver securities.
To reduce backlogs, ISDA completed a solution known as the ISDA Novations Protocol in 2005.
International Swaps and Derivatives Association. (2007) Annual operations benchmarking survey, http://www.isda.org, accessed 10 May 2008.
Partnoy, F. (2002) ISDA, NASD, CFMA, and SDNY: The four horsemen of derivatives regulation. Brookings-Wharton Papers on Financial Services 2002, pp. 213–252.
Gottlieb, C. (2007) Derivative markets, background note for CEPS. Harvard Law School Symposium, Louveciennes, 29–31 March.
In fact, within the ISDA end-users have no voting rights. Consequently their role in policy-making, respectively, standard setting is marginal.
Among the initiatives, in February 1995 a working group established by the central banks of the group of 10 countries published a report on macro-prudential risks from derivative activity. They mainly recommended enhancing the transparency in the market by expanding national central banks’ data collection efforts consistently across countries. In 1996, they published concrete proposals to improve and enhance data collection of global derivatives markets. In 1998, another report on the settlement procedures and counterparty credit risk management in OTC derivatives recommended prudential supervisors to review the backlogs and associated risks at institutions they supervise (especially derivative dealers), to assess the effectiveness of the institutions’ policies and procedures for limiting the associated risks and to encourage improvements in practices where appropriate. The report also urged supervisors to develop supervisory guidance on the use of collateral as a means of reducing credit risk, including guidance on operational risks and on legal due diligence and to take action where necessary to reduce legal uncertainty about the enforceability of collateral agreements. (For more details on the sequence of regulatory initiatives consult www.bis.org).
Bank for International Settlement. (1995) Issues of Measurements Related to Market Size and Macro-Prudential Risks in Derivatives Markets. Basel. Report prepared by a working group established by the central banks of the group of 10 countries, February.
See Bank for International Settlement. (2004) Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. Basel, June.
Default correlation across a pool of loans forming the collateral of a CDO can have a significant impact on the risks and market values of individual CDO tranches. Currently, the weakest link in the risk measurement and pricing of CDO is the modelling of default correlation. There is relatively little emphasis in practice on data or analysis bearing on default correlation. When valuing CDO, somewhat arbitrary ‘copula’ default correlation models are typically calibrated to the observed prices of CDS-index tranches, a class of derivatives that behave much like CDO. See39
In theory, these tools are expected to capture, on a high frequency basis, the full exposure of the firm to a sufficiently broad range of adverse conditions, the aggregate exposure to specific types of different risk factors and types of counterparties, the potential interactions among those factors, the effects of a general loss of liquidity and confidence in markets, and the constraints on the ability of the firm to move to reduce its exposure to further losses.
See Federal Reserve Bank of New York. (2007) Statement Regarding Progress in Credit Derivatives Markets. New York. Federal Reserve Bank of New York, September.
For example, treating all pairs of names within a given industrial sector as if they have the same default correlation, and treating all pairs of names not within the same industrial sector as if they have the same default correlation. See39
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Ayadi, R., Behr, P. On the necessity to regulate credit derivatives markets. J Bank Regul 10, 179–201 (2009). https://doi.org/10.1057/jbr.2009.3
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DOI: https://doi.org/10.1057/jbr.2009.3