10 The Market for Credit Risk Transfer Vehicles: How Well Is It Functioning and What Are the Future Challenges?

Garry Schinasi
Published Date:
December 2005
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The market for instruments that transfer credit risk from one investor to another—vehicles such as credit default swaps and collateralized debt obligations—has experienced tremendous growth since the mid-1990s.105 According to the British Bankers’ Association report for 2003–2004 (British Bankers’ Association, 2004), the notional value of credit derivatives traded in the global marketplace expanded to $3.5 trillion, up from around $1.2 trillion in 2001 and $0.2 trillion in 1997.106 Around 45 percent of this activity occurred in London and 41 percent in the United States. A variety of market participants—including commercial and investment banks, and institutional investors (such as mutual funds, insurance companies, pension funds, and hedge funds)—are now using the market to hedge or take on credit risk (Figures 10.1 and 10.2).

Figure 10.1.Global Credit Derivatives Market Size and Structure

Source: British Bankers’ Association (2004).

Note: Based on 2004 estimated market size and 2005 estimated shares of sales and purchases of protection.

CDO= Collateral debt obligation.

1“Other” includes government and export credit agencies, mutual funds, and pension funds.

Figure 10.2.Key Characteristics of Credit Derivatives Markets

Source: British Bankers’ Association, Credit Derivatives Report 2003/2004.

Measured in terms of notional principal—the reference amount on contracts—the credit risk transfer market is still small compared with the entire over-the-counter (OTC) derivatives market, which amounted to about $220 trillion at end-June 2004. This comparison significantly understates the relative amounts at risk in credit risk transfer contracts compared with most OTC derivatives contracts. For a standardized contract such as an interest rate swap, credit exposure is typically equivalent to about 3 percent to 5 percent of the notional principal. By contrast, for a credit derivative, credit exposure could be up to 100 percent of the notional amount because some credit derivatives involve the exchange of a cash flow equivalent to the principal amount of the underlying credit instrument when they are exercised, whereas principal amounts are not exchanged in standardized interest rate swaps. Moreover, credit risk transfers will probably account for an increasing share of OTC derivatives markets owing to their rapid growth—which some market participants predict could range around 40 percent to 50 percent per year over coming years (see BBA, 2004).

As the markets mature and grow over time, credit risk transfers have the potential to enhance the efficiency and stability of credit markets overall and improve the allocation of capital. By separating credit origination from credit risk bearing, these instruments can make credit markets more efficient. They can also help to reduce the overall concentration of credit risk in financial systems by making it easier for nonbank institutions to take on the credit risks that banks traditionally hold. In addition, credit risk transfers allow banks and other financial institutions to diversify their credit exposures across markets and sectors. They also facilitate the trading of credit risk, which can help financial and nonfinancial institutions manage their credit exposures more flexibly. Finally, liquid credit risk transfer markets can augment price discovery and provide price information that usefully supplements the information available from more traditional credit markets.

At the same time, these instruments and markets are currently being driven by regulatory arbitrage, involve nontraditional players, and are adding to the complexity of financial transactions and markets. In this way—and as explained in more detail in the chapter—they have posed new challenges or intensified existing ones. Many of these challenges surfaced during the global credit derivatives markets’ first serious test in 2001–2002 in the form of a U.S. recession and global economic slowdown following a relatively short period of very rapid growth. It was again tested in mid-2005 as two U.S. automobile manufacturers and traditional corporate stalwarts had their credit ratings downgraded significantly, creating turbulence in the market for corporate bonds and the global credit derivatives markets.107

Thus, alongside the potential benefits of these significant credit instruments, these market tests revealed several features about credit derivative contracts and markets that warrant further attention. First, they are reducing transparency of the institutional distribution of credit risk and its concentration. Second, while they are dispersing credit risk to a broader set of market participants, they may be creating or magnifying channels through which the distress associated with credit events could spread across institutions and markets (including through the web of rapidly shifting counterparty exposures). Third, these instruments seem to have created demand for credit risk by a much larger and different set of market participants, generally less regulated than banks, or even not regulated, and not necessarily having the experience required for properly pricing or managing these risks. Finally, by their very nature, credit risk transfer mechanisms are leveraged instruments, and can add to the total amount of credit that is internally created within the financial system, thereby increasing the potential for mispricing and misallocation of capital. For these reasons, the market’s ability to efficiently and effectively transfer credit risk potentially has implications for financial efficiency, if not financial stability.108

The Market’s Tests During the Slowdown of 2001–2002 and Corporate Downgrades in 2005

During the slowdown in global growth in 2001 and 2002, financial strains on corporate and sovereign entities gave rise to a number of credit events, some of which triggered payments on—or legal disputes about—credit risk transfer instruments. In 2001, amid an unusually large cyclical erosion in U.S. corporate profits relative to GDP, corporate defaults rose to annual record levels, with 211 issuers defaulting on $115 billion in debt. In January 2002, corporate defaults reached new monthly highs, with 41 issuers defaulting on $31 billion in debt. Defaults were more clustered during this period than expected, and recovery rates were lower than expected. Accordingly, market participants reportedly began to adjust the pricing and collateral terms of contracts and scrutinize structured financial instruments (involving underlying and derivatives instruments) more closely.

Some investors and credit-protection sellers sustained sharp losses. For example, American Express lost $370 million in June 2001 on a $1.4 billion collateralized debt obligation (CDO) portfolio. In addition, several internationally active financial institutions had already experienced losses on credit enhancement transactions with Enron while it was in the midst of bankruptcy proceedings, the full extent of which will not be known with certainty until the proceedings and related lawsuits are completed.109 At the time there was also considerable uncertainty about the performance of some of the credit risk transfers used to hedge credit exposures to Enron.110 According to credit analysts and market participants, except for Enron, no private counterparties to credit risk transfer vehicles had defaulted, and the markets were at that time judged as having worked reasonably effectively to insure credit risk. Dealers and credit rating agencies saw activities in credit risk transfer vehicles, which in the CDO market was reportedly fairly well-sustained through September 11, 2001, as reflecting continued investor and dealer appetite for credit risk.

As a result of the financial strains and credit events in 2001–2002, particularly the private default events involving Railtrack111 and Enron, weaknesses in the legal and operational infrastructure of OTC derivatives markets resurfaced—as they had during the Long-Term Capital Management (LTCM) crisis in 1998—and raised concerns about the performance and enforceability of some credit risk transfers.112 Three examples serve to illustrate this. First, hedge funds had arranged credit default swaps113 to hedge credit risk in convertible bonds issued by Railtrack, which was placed in administration in October 2001. Afterward, uncertainty prevailed about whether convertible bonds could be delivered for the swaps. Some of this uncertainty was addressed in November 2001 when the International Swaps and Derivatives Association (ISDA) issued supplementary documentation.114

Second, in December 2001, Enron’s failure and its involvement in credit and other OTC derivatives markets highlighted longstanding uncertainties about the legal effectiveness in bankruptcy of “closeout netting” provisions in OTC derivatives documentation (Box 10.1).115 Without closeout netting, OTC derivatives holders could be exposed to a defaulting counterpart on a gross, rather than net, basis (U.S. banks’ gross OTC derivatives exposures are about four times larger than their net exposures). While there has been much discussion in both private and official forums on the importance of resolving some of this uncertainty, and even agreement on how to do so, as of May 2005, U.S. bankruptcy legislation that would resolve this uncertainty for U.S. contracts was still pending in the U.S. Congress.

Third, in early 2002, JP Morgan Chase sued insurance companies that failed to pay off on $965 million in surety bonds issued to JP Morgan as insurance against the failure of Enron to make good on forward contracts involving the delivery of natural gas and oil. Surety bonds typically are used as a general form of protection against nonperformance of delivery of goods.116 The insurance companies alleged that JP Morgan had no intention of taking physical delivery and instead used the transactions as a way of extending loans to Enron collateralized by the surety bonds. These examples together highlight, in actual practice, the opacity and legal uncertainties associated with credit risk transfers.117

Argentina’s default in December 2001 also constituted a major test of the rapidly growing market for emerging-market credit default swaps. At that time, there were no reliable estimates or surveys of the total outstanding amount of Argentine default protection, but market observers suggested that the total could be in the range of $10 billion to $15 billion in notional amount covering a large number of contracts. Argentina concluded its global debt exchange on June 10, 2005, after some delays related to court proceedings in New York. Creditors holding about 76 percent of Argentina’s external debt had agreed to the terms of Argentina’s debt-restructuring offer. Notwithstanding the debt restructuring, there are still unresolved principal claims amounting to almost US$20 billion.

During the period following the experiences in 2001 and early 2002, and those at the end of 2004, derivatives markets encountered few if any difficulties. In mid-2005, the pending disputes involving the bankruptcy of Parmalat were coming to a critical point. In addition, markets were speculating whether General Motors (GM) would be able to avoid bankruptcy, and the credit rating agency Standard and Poors downgraded Ford’s debt to the lowest rating for investment grade bonds and downgraded GM’s debt to below-investment grade (or junk status). Because the debt of both of these companies is linked to credit derivatives—specifically, are included in tranches of CDOs—both the cash markets for corporate bonds and the credit derivatives markets experienced significant price movements and financial flows reflecting portfolio rebalancing. As noted in Chapter 9, both financial market participants and regulators have recently called for action to improve the stability of these markets.118 It remains to be seen how well these still developing derivatives markets will withstand the financial market pressures surrounding these significant corporate events.

In sum, some progress has been made in addressing operational “teething problems” in the nascent credit risk transfer markets, particularly for standardized simple instruments such as credit default swaps. At the same time, some operational issues highlighted by the downturn in 2001–2002 and the breaches of corporate governance discussed above remain to be addressed. Moreover, there may be significant operational risks in the CDO market, which involves heterogeneous instruments and special purpose vehicles (SPVs) that can be complex and relatively nontransparent to investors. In addition, the potential for CDO investors to experience sudden and larger-than-anticipated losses (as in the case of American Express) raises a question about whether such vehicles pose reputational risks to banks. An originating bank might prefer to compensate its investors for losses or buy back the product, rather than risk damage to its reputation that could prevent it from selling such products in the future. If this occurred, the bank would wind up with a loss on the underlying credit exposure despite having bought credit protection in what seemingly had been an arms-length transaction.

Box 10.1.Financial Implications of Enron’s Bankruptcy

Enron has come to symbolize the use of aggressive accounting techniques by major companies to mask excessive leverage and weak earnings. The company’s collapse—the largest U.S. Chapter 11 bankruptcy to that time—also caused significant volatility in financial markets and led to substantial losses for financial institutions and institutional and retail investors. These effects did not have systemic financial consequences, because exposures to Enron were generally well diversified across institutions and markets. But at the time there were significant uncertainties, including the likelihood that hidden losses would be uncovered as Enron’s highly complex financial operations were unwound; the magnitude of bank exposures to other energy companies that were also facing difficulties because of Enron’s collapse; the size and structure of Enron’s derivatives books; and the extent of insurance company exposure.

As described in the chapter, Enron’s failure highlighted uncertainties about the effective functioning of credit risk transfer vehicles. It also underscored three broader capital-markets issues.

Inadequate oversight of financial activities of nonfinancial corporations. Enron was the main dealer, market maker, and liquidity provider in major segments of the OTC energy derivatives markets, and was also active in other derivatives markets segments (at the end of September 2001, its overall derivatives trading liabilities stood at about US$19 billion). Despite its size, complexity (including many off-balance-sheet special purpose vehicles), and central role in the energy derivatives markets, its OTC derivatives activities were essentially unregulated.1 In particular, it was not required to disclose information about its risks to counterparties; disclose information about market prices or conditions, even in markets that it dominated; or set aside prudential capital against trading risks. These gaps contributed to its demise and the associated financial market implications. Because its trading unit’s capital was not segregated from the parent company’s capital, a loss of confidence in the parent company’s soundness led its banks to withdraw credit lines, which in turn contributed to a collapse in its trading operation. Some observers have since called for revisions to the 2000 Commodity Futures Modernization Act that exempted energy derivatives activities from key regulatory provisions, and U.S. Congressional hearings have since discussed this issue. Nevertheless, even if these exemptions had not been made, Enron’s activities in credit and other financial derivatives markets would still have been essentially unregulated.

Ineffective private market discipline, disclosure, corporate governance, and auditing. Enron’s financial difficulties and vulnerabilities, including those associated with its extensive off-balance-sheet transactions, seemed to have gone undetected by analysts as well as its shareholders and creditors until it was on the brink of bankruptcy. In part, this reflected inadequate accounting rules and standards as well as errors by its auditors, who (among other oversights) did not uncover related-party transactions or require Enron to properly consolidate its many and complex off-balance-sheet special purpose vehicles (SPVs) in its financial statements. In October 2001, the correction of this and other errors resulted in a restatement of income since 1997 by US$600 million and a writedown of shareholder equity by US$1.2 billion. Questions also arose about the auditor’s possible conflict of interest owing to its parent company’s extensive consulting business with Enron (in 2000 Enron paid it US$25 million in auditing fees and US$27 million in consulting fees). Along with allegations that the auditor destroyed documents relevant to an SEC inquiry, these revelations led to widespread calls for a closer examination of auditing standards and practices.

Misallocation of retirement savings. More than 10,000 Enron employees held most of their retirement savings in Enron stock, including Enron’s contributions (entirely in company stock)—which the company prohibited them from selling until age 50. In addition, for three weeks in October 2000, Enron required its employees to freeze their asset allocations as it switched plan administrators, during which time Enron stock fell by 35 percent. As a consequence of the pension plan’s poor diversification and inflexibility, during 2001 a large share of employee savings were wiped out as Enron’s stock price plummeted from about US$90 to less than US$1. In the early part of 2002, the U.S. authorities formed a working group to consider potential reforms to the Employee Retirement Income Security Act (ERISA) rules that govern private pension investments, and the U.S. Congress held hearings to discuss (among other topics) how to address gaps in ERISA that permitted a high concentration of Enron stock in the company’s pension fund.

1Testimony of Vincent Viola, Chairman, New York Mercantile Exchange, before the Senate Energy and Natural Resources Committee, January 29, 2002. Energy derivatives are subject to the antifraud and antimanipulation provisions of the Commodity Exchange Act, however.

Remaining and Future Challenges

Markets for credit risk transfers are still in a developmental stage, typical of the product cycle for new markets. In 2001–2002, and again in 2004–2005, the market seemed to be able to cope with a series of credit events that emerged as the global economy slowed. Payments were made by credit risk protection sellers to protection buyers, even though in some cases this occurred only after arbitration. At the same time, these events revealed some challenges in using these instruments and in understanding their impact on financial stability.

Industry Challenges

First, credit derivatives can reduce the transparency about who owns credit risk, in part because the transfer of credit risk reduces the informational content of balance sheets without necessarily providing additional information about where the risk is transferred or even how it is priced. By reducing transparency about credit exposures, the growth in credit derivatives complicates the assessment of private credit risk and counterparty risk in individual institutions. It also makes it more difficult to assess the overall distribution of credit risk across institutions and markets, and to assess the challenges that credit risk transfers might pose to liquidity conditions in related underlying and derivatives markets (that is, it poses liquidity risks) and more generally to financial market stability. The fact that nontraditional entities—such as Enron—are now trading in these markets and not subject to the same disclosure rules and standards as regulated financial institutions further adds to the lack of transparency. Moreover, as illustrated by Enron, there are gaps in accounting rules and standards, particularly regarding SPVs, as well as in auditing practices, that apparently are also contributing to a lack of transparency.119

Second, regulatory arbitrage involving credit risk transfer vehicles is shifting credit risk exposures outside the banking system. Concern arises because regulatory incentives appear to encourage banks to transfer credit risk to other institutions—such as hedge funds, pension funds, and insurance companies—that are not prudentially regulated as banks are, especially with regard to capital adequacy, and that have not traditionally had cultures or risk management systems attuned to credit risk. Nevertheless, these nonbank financial institutions manage a large volume of assets distributed across global markets and are part of the global network of counterparty risk exposures. Some believe they are the weak links in the chain of counterparty relationships. A string of unanticipated credit events causing those market participants to experience much larger than expected losses could lead them to reduce their willingness to supply credit protection when banks need it most. It could also lead to a withdrawal of capital devoted to market making in credit risk transfer vehicles. These reactions, if sharp and sustained, could significantly impair liquidity and create volatility in the credit derivatives and related markets, similar to the way in which the threat of default by LTCM affected credit markets in 1998.

Third, because the use of credit risk transfer vehicles tends to increase the links between markets and institutions, these new instruments tend to increase the potential for spillovers across markets or to intensify existing channels for spillovers. For example, unanticipated shocks to an underlying bond or loan transaction for which there is an associated credit derivative would give rise to increased demand for credit hedges. During a period of turbulence in the underlying market, situations could arise in which there would be one-sided, illiquid, and volatile credit derivatives markets that, through counterparty relationships, could spill over into connected markets. Likewise, in a market with relatively few very large counterparties, a cluster of credit events could trigger payments on many contracts at once and put considerable liquidity demands on one or more of the relatively small number of major market makers.120 If these market makers had to sell a wide range of liquid securities from their portfolios to cover payments, volatility could rise sharply in a variety of markets at once. In addition, because a number of the institutions that sell protection—particularly insurance companies—typically have access to bank credit lines, they might tap these lines to fund payments on credit risk transfer contracts, potentially putting pressure on bank liquidity. Finally, credit hedges could fail to perform as expected if a major protection seller came under financial stress and either contested the legality of the contract or was unable to pay. This could leave banks with unhedged credit positions, give rise to an increase in the demand for credit hedges or unloading of credit positions, and potentially lead to an increase in credit market volatility.

These transmission mechanisms can be magnified by the leverage inherent in credit derivatives. As with other OTC derivatives, credit derivatives allow investors to take on exposure to an underlying credit instrument while committing much less in funds than would be required to actually buy the instrument. In addition, a single underlying credit transaction can give rise to multiple gross credit derivative transactions as dealers rehedge and lay exposures off on one another. The total gross credit exposures created through this process can, in principle, substantially exceed the exposure on the underlying instrument. For example, an initial $1 billion credit transaction might give rise to five rounds of hedging as dealers pass the exposure around the market. Each transaction involves the creation of another $1 billion in gross exposure to one counterparty; five such transactions therefore give rise to $5 billion in gross credit exposure.

A fourth challenge arises because these are relatively new instruments and markets, and investor access to credit risk markets is easier, so a significant amount of capital from nontraditional sources is flowing into credit risk transfers. Concerns have been raised that the costs and benefits of these instruments are not fully understood. More generally, the tendency for credit derivative spreads to be volatile and even decline below the spreads on the underlying bonds raises questions about whether participants in the credit derivatives markets—especially those that have not traditionally managed credit risks—have yet learned how to price these contracts appropriately. In early 2001, a strong supply of credit protection—including from institutional investors and money managers—compared with demand for credit protection from banks apparently contributed to narrow and sometimes even negative spreads between the credit default swap premium and the credit spread on the underlying security (Figure 10.3).121 Whether contracts are being properly priced is difficult to know, in part because the theory of credit derivatives pricing is still developing. If, in fact, credit derivatives prices “overshoot” and are excessively volatile relative to the price of the underlying credit, signals about credit risks would be distorted. Accordingly, it would also raise questions about whether credit risk transfer vehicles improve or reduce the efficiency of credit allocation in markets.

Figure 10.3.Spread Between Credit Derivatives Premium and Underlying Bond Spread1

(In basis points)

Source: Deutsche Bank.

1Average for credit default swaps on four investment grade U.S. corporations.

Looking ahead, improvements to the infrastructure for, and transparency of, credit risk transfers could help them to develop more fully, help market participants to manage the risks, and make the markets more efficient. This occurred in the OTC swaps markets during the 1990s, and there is good reason to expect the credit derivatives markets will mature through time as well. As of mid-2005 it is still too early to judge whether these markets have matured, in part because they are being tested once again with the downgrades of debt issued by GM and Ford, whose corporate bonds are widely held by institutional investors and are often within a tranche of collateralized debt obligations. As this book was being completed, various hedge funds were alleged to be in serious financial trouble as a result of their trading strategies involving GM and Ford bonds, and some counterparty major banks also were alleged to have experienced serious losses on their proprietary trading activities. Nevertheless, through mid-2005 the markets seem to have taken these quite remarkable events in stride. Infrastructure improvements in the future will no doubt include better documentation that further refines the definition of a credit event. Bankruptcy legislation that would establish the legal effectiveness of close-out netting and a convergence in bankruptcy laws about what constitutes a default would also encourage further maturation of the market. Better information about the size and structure of the market and the exposures of bank and nonbank financial institutions active in the market would help market participants assess the attendant risks and gauge whether they are well managed by the institutions involved in the markets.

Implications for Retail Investors

Another issue that could become more important in the future is the small, but increasing, exposure of retail investors to the risks associated with credit risk transfers. Hard data on retail participation and exposures are not available, but retail investors are searching for higher-yielding alternatives to their traditional investment instruments such as stocks, government and corporate bonds, money-market mutual funds, and bank deposits in light of the low returns on such instruments through mid-2005. Retail demand may also reflect the longer-term, underlying trends of disintermediation and more direct retail investment in asset markets. In this environment, retail investors have increasingly invested in, and become exposed to the risks in, a variety of structured products, including guaranteed funds—providing downside protection by hedging exposures in derivatives markets—and mutual funds that own CDOs.

In mid-2005, credit analysts perceived that retail investors were participating in a relatively limited way in credit risk transfer markets through three main channels: investments by high net worth individuals, mutual funds, and hedge funds.122 Although data are not available, in view of their recent proliferation, hedge funds may be a principal channel for direct or indirect retail participation in credit risk transfer markets. Hedge funds invest in CDOs and employ credit default swaps to hedge the credit risk in convertible bond arbitrage strategies. Retail investments in these strategies have become more accessible as hedge funds have reduced minimum investment requirements and instituted less restrictive “lock up” rules that allow investors to withdraw more quickly. Hedge funds that meet enhanced disclosure and regulatory requirements are allowed to increase the number of investors (thereby reducing their minimum investments), and are more readily accessible to pension funds and other institutional investors. Moreover, minimum investment rules are increasingly irrelevant, because one can invest any amount in recently created offshore-based funds, structured as closed-end funds, that invest 100 percent of their assets in hedge funds (“funds of funds”). It is estimated that about 482 funds of funds exist and account for about 20 percent to 25 percent of the hedge fund universe of about $950 billion in capital under management (in 2004).123

Even if direct involvement and exposure in credit risk transfer mechanisms is limited, retail investors can become exposed to credit risk in many less-transparent ways. For example, shareholders of American Express stock were adversely affected when it became known that American Express had taken significant losses on its investments in CDOs, which involved credit risk transfer mechanisms. Likewise, many retail investors may hold mutual funds that invest in riskier credit instruments to enhance their yields. One illustration of this is the unexpected impact of the collapse of Enron on Japanese mutual funds. These mutual funds invested in Enron’s samurai bonds and marketed shares in their funds to Japanese retail investors as a high yield alternative to bank deposits. The collapse of Enron caused a run on these mutual funds, as investors withdrew 2 trillion yen (US$16 billion) from 27 mutual funds. This was well in excess of the funds’ holdings of Enron samurai bonds (totaling 66 billion yen). The Bank of Japan had to intervene by injecting 6 trillion yen (US$49 billion) of liquidity to offset the potential adverse impact on the banking system. This injection followed an earlier injection of more than 8 trillion yen resulting from the impact of the liquidity effects in Japan following the events of September 11, 2001.

As a result of all these changes, the hedge fund industry, including the segment that is active in credit risk transfer markets, is widely considered to have been “democratized.” For instance, many of the new retail investors are not the traditional high net worth individuals—minimum investments in hedge funds in Europe, Japan, and the United States are now as low as 20,000 euro (or $18,000). Reflecting this easier access, retail hedge fund investments surged from $8 billion in 2000 to over $22 billion in 2001 through September, and have continued to increase rapidly since then. The potential for retail participation will increase further as more hedge fund investment vehicles begin to be offered publicly.

The challenge for active retail participation in credit risk transfer markets seems to be mainly an investor protection issue. As noted above, even some sophisticated market participants have encountered trials in investing in and understanding how best to use credit risk transfers. In this regard, there may be cause for concern about first, the ability of retail investors to understand fully the risks in credit risk transfer vehicles and price them accordingly and second, whether the disclosure and transparency standards developed for other instruments, such as mutual funds, need to be updated.

The activities of intermediaries that offer products such as guaranteed funds might be altering the distribution of credit risks in the financial system, adding a further complication. Internationally active financial institutions trade actively in global exchange-traded and OTC derivatives markets to hedge their exposures to the retail products they sell, in effect arbitraging between professional hedging markets and the retail markets. Because this activity effectively transfers credit risk from the guaranteed fund to its counterparties—which can include a wide range of financial institutions such as hedge funds and insurance companies—it both complicates an assessment of who bears the ultimate risks associated with the products and raises questions about whether the counterparties can manage these risks well.

As retail investor participation grows over time, the broader dispersion of credit risks across investors could improve the effectiveness of credit risk transfer markets in mitigating the financial effects of periods of economic stress. Nevertheless, the relatively limited sophistication of individual investors and questions about disclosure and transparency could have implications for financial efficiency and stability. For instance, herding or bandwagon effects could occur in credit risk transfer markets if retail investment decisions are driven primarily by investor sentiment rather than information about changing fundamentals. Similarly, if disclosure and transparency to retail investors about the risks in these vehicles are insufficient, the potential for investment mistakes to occur increases, as does the potential for rapid unwinding of investment positions when these mistakes are discovered. Both these effects would tend to increase volatility in credit prices and spreads, and might also adversely affect the efficient allocation of credit in the financial system.


This chapter draws on material in IMF (2002b). The author is grateful to his colleagues for the joint effort at the time, and for their permission to draw on this publication.


The U.S. Office of the Comptroller of the Currency (OCC), which regulates and supervises nationally chartered banks, reports similar growth for credit derivatives activity in the United States. The notional value of credit derivatives outstanding on the balance sheets of OCC-regulated banks expanded to $2.4 trillion at the end of 2004, up from $0.4 trillion in 2001 and $0.055 trillion in 1997 (U.S. Comptroller of the Currency, 2005).


As noted in Greenspan (2005, p. 2), “To be sure, the benefits of derivatives, both to individual institutions and to the financial system and economy as a whole, could be diminished, and financial instability could result, if the risks associated with their use are not managed effectively. Of particular importance is the management of counterparty credit risks. Risk transfer through derivatives is effective only if the parties to whom risk is transferred can perform their contractual obligations. 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.” This echoes concerns raised in Greenspan (2002), “derivatives have provided greater flexibility to our financial system. But their very complexity could leave counterparties vulnerable to significant risk that they do not currently recognize, and hence, these instruments potentially expose the overall system if mistakes are large. In that regard, the market’s reaction to the revelations about Enron provides encouragement that the force of market discipline can be counted on over time to foster much greater transparency and increased clarity and completeness in the accounting treatment of derivatives.”


As of mid-2005, Enron was still “in the midst of restructuring various businesses for distribution as ongoing companies to its creditors and liquidating its remaining operations.” This quotation is from the banner on Enron’s Web site, which can be accessed via the Internet at


Railtrack was a privately owned and publicly traded company that controlled Britain’s rail infrastructure. It was put into administration (that is, under the control of government-appointed administrators) in October 2001. The company had just over a quarter million shareholders, and the vast majority of them (about 254,000) held less than 5,000 shares, controlling only about 17 percent of the company. (More information is available from the BBC Web site:


Earlier watershed credit events included the Conseco restructuring (September 2000), which raised issues about whether restructuring should be treated as a credit event, and the National Power demerger (November 2000), which raised issues about the treatment of credit derivatives involving obligations split between successor companies. These issues were subsequently addressed in supplements and user guides issued by the International Swaps and Derivatives Association. For a discussion of legal risks in OTC derivatives markets, including credit derivatives, see Box 3.6 in Schinasi and others (2000).


Credit default swap contracts involve the payment of periodic premiums from a protection buyer to a protection seller. In the event that a predefined “credit event” such as default occurs, the protection seller makes a payment related to the market value of an underlying reference instrument such as a bond. For example, the protection seller might either buy the reference instrument at par value from the protection buyer, or make a payment that is equivalent to the difference between par and market value. For more technical details on these and other instruments see Handbook of Credit Derivatives (1999).


ISDA develops standards and serves as a forum for the discussion of legal and documentation issues surrounding OTC derivatives contracts.


Closeout netting—the settlement of net outstanding obligations by a single payment in the event of default—mitigates the risk that a bankrupt counterparty will cherry pick its obligations by attempting to enforce those that have positive value to it while repudiating the others. See Schinasi and others (2000).


A surety bond is a bond issued by one party, the surety, guaranteeing that the party will perform certain acts promised by another or pay a stipulated sum, up to the bond limit, in lieu of performance should the principal fail to perform.


The suit was settled out of court in early 2003, with JP Morgan incurring a before-tax writeoff (loss) of about $400 million (see Chapter 11 for further details).


See Corrigan (2005) and Geithner (2004a, 2004b).


See Volker (2002).


Global data are not available, but in the United States at end 2004, one U.S. bank held 45 percent of the banking system’s outstanding notional credit derivatives; the top two banks held 67 percent, and the top three banks held 87 percent. (See Table 1 in U.S. Comptroller of the Currency, 2005.) As noted elsewhere, banks are net buyers of credit protection; it is unclear whether holdings of net protection sellers are similarly concentrated.


The premium is the spread over the London Interbank Offered Rate (LIBOR) that is paid for credit protection. Although the analytical theory is still being developed, the difference between the premium on a credit derivative and the credit spread on the underlying instrument partly reflects differences in tax treatment, liquidity, and counterparty risks for a bond versus a credit default swap. These structural features might limit the extent to which market participants can arbitrage away the difference in spreads between the two markets. The sharp blowout in spreads during September 2001 probably reflected an increased demand for credit protection following the terrorist attacks.


Retail participation takes place through mutual funds investing in CDOs rather than credit derivatives, because credit derivatives trade only on OTC markets made up of financial institution counterparties.


The estimate of $950 billion in 2004 is from Van Hedge Fund Advisors International, 2005.

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