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Credit Derivatives Gaining Popularity Yet Higher Scrutiny is Required
RiskCenter.com (September 26, 2005)

Location: New York
Author: Ellen J. Silverman
Date: Monday, September 26, 2005
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Credit derivatives have soared in popularity on Wall Street, forcing regulators to step up their scrutiny of this rapidly growing marketplace.

Derivatives are investments that derive their value from something else, such as stock options that trade based on the price of an underlying stock. Credit derivatives are bought by investors as protection against a possible default on an underlying bond. One of the most common credit derivatives, a credit default swap, calls for the seller to pay if the underlying bonds go into default. The swaps are akin to insurance for investors, and supporters say they help spread and manage risk. The credit derivatives market overall was worth about $8.4 trillion last year, and has roughly doubled in each of the last three years, according to the International Swaps and Derivatives Association (ISDA).

Hedge funds that specialize in bonds have become big players in the derivatives space. A hedge fund can profit is by selling credit default swaps to a bank, for example. If the underlying bonds go into default, the hedge fund covers the bank's losses. But if there's no default, the hedge fund profits. "Our view is that the growth of the market ... has really helped disseminate risk through the system and minimize its concentration among certain lenders," said Louise Marshall, chief spokeswoman for ISDA. "Our basic stance is that (credit derivatives) spread risk more thinly and evenly as opposed to it being concentrated within banks," she said.

Regulators want to ward off trouble in the rapidly growing market by making sure the sellers of these contracts are stable and have sufficient funds to meet their obligations. "Risk transfer through derivatives is effective only if the parties to whom risk is transferred can perform their contractual obligations," Federal Reserve Chairman Alan Greenspan said in a speech last spring. "These parties include both derivatives dealers that act as intermediaries in these markets and hedge funds and other nonbank financial entities that increasingly are the ultimate bearers of risk." Greenspan also acknowledged the benefits of derivatives, noting their risk-management features were "key factors underpinning the greater resilience of our largest financial institutions." But regulators have also raised concerns. Last week, the Federal Reserve Board of New York met with several Wall Street firms to discuss its worries that the contracts are not being processed in a timely way, the Fed announced.

The regulators worry that a series of big corporate defaults, while unlikely, could nevertheless pose substantial risks to financial markets with ripple effects on interest rates and the broader economy. Tanya Azarchs, a managing director in the financial institutions ratings practice at Standard and Poor's, noted several concerns about the rapid growth in derivatives. First, many hedge funds and other investors move so quickly that a big default or downgrade could trigger simultaneous sell signals, causing everyone to head for the exits at once. "In that stampede, liquidity dries up as everyone is selling and not buying," she said. Another problem is with how trades are settled, adding it was troubling to see that back-office operations of many players in credit derivatives markets were in disarray. "That makes you question whether anything else is wrong as well," she said. Lastly, if trades don't get processed accurately after a default or series of defaults, there could be flood of lawsuits that can become "really messy and difficult for the court system" if the paperwork is in disarray, she said.

Do individual investors need to worry? Only if they panic rather than waiting to see what shakes out, according to Azarchs. "In those periods of market dislocation, smaller investors could be tempted to liquidate their positions at a substantial loss, which could lead to long-term investment losses," she said. "That's where they'd first feel it, before they felt any major repercussions on monetary policy."

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Article Printed From RiskCenter.com

 

 

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