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Credit derivatives market continues to grow apace despite concerns Back  
Despite concern that the use of credit derivatives is leading to financial markets instability, the notional amount of outstanding credit derivatives more than doubled in the past year, growing by 109 per cent to $26 trillion. Products increasing in use include loan-only CDS, CDS of Asset-Backed Securities (ABCDS), and CDS on CDOs, and the potential for credit derivatives to find new and better ways for investors to add, reduce or otherwise manage credit exposure appears limitless, writes Chris Case.
Since the mid 1990s, credit derivatives have exploded onto the global stage in terms of availability and diversity of product, with volumes also rocketing. According to a survey by the International Swaps and Derivatives Association (ISDA)*, the notional amount of outstanding credit derivatives more than doubled in the past year, growing by 109 per cent to cover $26 trillion of securities. Put in context, ISDA also found that interest rate derivatives grew by 25 per cent and equity derivatives by 32 per cent over the same period.

One of the largest components of the credit derivative market is the Credit Default Swap (CDS). A CDS is an instrument designed to allow the transfer of credit exposure on underlying bonds, loans or other credit products.
A CDS is often viewed in a similar way to an insurance policy. Two counterparties effectively ‘exchange’ protection (one buying, the other selling) on an underlying reference entity. The buyer of protection pays a periodic fee, in return for a contingent payment by the seller in the case of a credit event on the underlying entity. They can therefore be used to synthetically create or hedge risk, by selling or buying ‘protection’ respectively on a given reference entity via a CDS.

Some of the earliest CDS were developed for bonds and loans related to central bank transactions. One of the first tests of this fledgling market was the Asian liquidity crisis of 1998. In that year, with yields rising dramatically on government bonds such as the Republic of Korea (9 per cent to over 14 per cent**), investors scrambled to find a way to minimise their losses.

Prior to this slump there was some concern as to whether or not CDS contracts had a sufficiently robust legal framework. However, the new product proved successful, as investors seeking to contain their exposure were able to find a hedge in CDS contracts on the Republic of Korea.

Trading houses in London were quick to realise the importance of this new credit product. Desks were restructured, enabling dealers who had previously only followed the corporate bond markets to access, and trade, CDS as well as bonds. The CDS product subsequently developed into the hugely diversified, heavily traded market it has now become, with growth consistently outstripping expectations

The market
The largest players currently include commercial banks, insurers, pension funds and hedge funds. According to ISDA, about 2,000 institutions now use CDS regularly.

Selling protection
CDS transactions, by their very nature, can be structured to suit an investor’s needs. They can therefore provide an extremely versatile investment opportunity.

For example, an investor may wish to take down risk on a particular credit, but only for a particular tenor, or currency. If no such bonds exist in the market, the investor can sell protection in a way that matches their investment requirements - assuming of course it can find someone willing to buy that protection from them.

Some investors may be restricted in terms of the bonds or loans they can buy. For example, a non-bank investor usually cannot gain access to the loan market, where the majority of borrowers issue. Instead, they can use a CDS transaction, opening a new range of credit investment previously denied to them.

CDS transactions are off-Balance Sheet, or put another way, do not need to be funded. This feature means that investors can achieve enhanced returns, as they do not need to make an up-front payment, only possibly post collateral. Also, some companies fund at levels which can reduce returns significantly, or even prohibit some investments in higher rated credits. CDS transactions can allow these companies to invest in credits which were previously out of reach for them.

Hedge Funds, for example, have made great use of the CDS market in recent years. Insurance companies have also increasingly become active as sellers of protection to enhance yields.

Buying protection
Some early buyers of protection were banks eager to look at CDS as a means of hedging their loan portfolios. The advantage of using a CDS transaction to hedge a loan rather than actually sell it, is that the borrower does not have to know that you are effectively selling risk on their name. CDS transactions are ‘Over-The-Counter’ instruments that reference the underlying credit. In other words they exist between the protection buyer and protection seller and do not trade over an exchange.

Since then the use of CDS as a means to reduce risk has become increasingly widespread. Some transactions require a company to reduce credit exposure even though they are positive about the credit, for example if they have limited line but wish to temporarily be involved in a new transaction. A CDS enables them to do this.

Since there is no transfer of ownership of the underlying asset under a CDS, as a means for hedging it can prove to be cheaper and more flexible than an assignment. Additionally, a CDS when triggered usually pays out within four to six weeks, unlike many other insurance policies, which can take six to twelve months.

A company may wish to manage its regulatory capital. Although different jurisdictions have slightly varying rules, generally a company can manage its risk weighted assets with CDS protection, potentially reducing it to zero if the transaction is cash collateralised. This can allow for the facilitation of new business.

Commercial banks, generally net buyers of protection, are the biggest players in the CDS market.

Another major product in the Credit Derivative world is the Collateralised Debt Obligation (CDO). This type of structure began with cash CDOs, groups of bonds sold into a special purpose vehicle, and the resulting pool of risk bundled up into increasingly risky parcels of credit and sold off. The buyers of the more ‘junior’ pieces of risk took the first defaults, and thus increased leverage. Buyers of the more ‘senior’ tranches took less risk, but because of the effects of correlation across a distribution of risk managed to achieve greater returns.

However cash CDOs were untidy, as the bonds had to be acquired, and usually did not neatly fit the risk requirements of the end investors.

Synthetic CDOs were the solution. By acquiring risk through selling CDS protection, a synthetic CDO can be tailor-made to fit requirements without having to worry about differing maturities, currencies or indeed absence of bonds in the first place.

Corporate bond issuance over the last couple of years has been low in comparison with previous years. Add to that the fact that many bonds issued when companies were desperate for cash 5 years ago are now redeeming, and it is clear options for investors were minimal. With investors cash-rich in a low interest rate world, these products have been a lifeline.

The disparity between demand for credit risk and the relative lack of supply has been taken up by the synthetic CDO, effectively creating risk when supply was scarce, and providing better risk profiles for investors into the bargain.

CDS indices
Another major product to have appeared in recent years is the CDS Index. In Europe, the iTraxx Indices have been created, with more than 35 banks licensed as market makers. The main index comprises 125 equally weighted European credits. As well as the main index, further sub-divisions are also traded, such as industry sectors, the 30 widest spread non-financial names, and sub-investment grade Crossover credits. There are even prices for options on these indices.

These products supply the investor with a ready-made tool to hedge a portfolio of credit exposures. Systemic market risk can be at least partly offset by buying CDS Index protection. If a portfolio manager feels the economic cycle is about to turn but that they do not have the time or ability to hedge the portfolio by selling each and every asset in turn, then they can buy CDS Index protection to give a broad market hedge.

They are very liquid, with volumes for most banks typically exceeding those of single name CDS contracts by a factor of 2 to 3. Investors are able to choose the index which most closely matches their hedging requirements.

The future
With recent issues concerning management of these types of transactions being addressed, such as better platforms for settlement, and more standardised documentation, the growth of credit derivatives looks set to continue for some time to come.

Products increasing in use include loan-only CDS, which bear a closer relationship to loan structures, CDS of Asset-Backed Securities (ABCDS), and CDS on CDOs. CDOs have been structured using risk from other CDO tranches (CDO squared). Other portfolio management tools include the Constant Proportion Portfolio Insurance strategy, which aims to generate out-performance to an underlying asset whilst reducing risk if the underlying asset under-performs.
Demand for CDS is also beginning to appear from those involved in trade transactions, as a hedge against income or receivables for example. Corporate institutions are tempted by the prospect of a new risk management tool alongside existing ones such as insurance or forfeiting, and also having more counterparties to work with.

The proportion of the credit world that has been utilised by credit derivatives is only a small fraction, whereas the interest rate derivative market is multiples of its underlying market. The potential for credit derivatives to find new and better ways for investors to add, reduce or otherwise manage credit exposure appears limitless.

*ISDA Mid-Year 2006 Market Survey, Tuesday, September 19, 2006.
**Republic of Korea 8.875 per cent 2008 Global Issue.

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