The growth in single name credit default swaps is fast establishing them as the building blocks of the 21st century credit market, eclipsing a bewildering array of more esoteric credit derivative products.
Standardised documents have done much to promote this advance, but there is still plenty of scope for misunderstanding and dispute.
Credit derivatives are a young market. This is obvious not just from the unbridled enthusiasm of many market practitioners, but from their confusion about how to refer to basic concepts and products.
What one banker calls a default swap another terms a credit swap; what some call a portfolio swap others describe as an unfunded CLO. This is an arena where everything from market share to basic terminology is up for grabs.
In fact, if a credit derivative is defined as any instrument which allows credit to be isolated from other financial risks, there are a number of established products which qualify for the name.
Credit insurance and credit guarantees, for example, transfer credit risk in an unfunded form and have been with us for decades.
What differentiates the modern credit derivatives market, born in the mid-1990s, from these older credit-isolating products is its use of standard documentation. That creates a common currency which all holders of debt can use to hedge their exposures.
"If an entity has several classes of illiquid debt outstanding - perhaps a few bonds in one currency, some bank loans in another and some commercial paper - the holders of all those debts can trade the credit using credit swaps," says Tim Frost, European head of credit derivatives trading at JP Morgan in London. "Credit derivatives can unlock those illiquid assets on their balance sheets."
The development of credit derivatives has been a story of gradually emerging standards and conventions. As the rules of the game have become better defined, ever greater numbers of participants have become involved.
The defining moment came in July 1999 with the publication of short form definitions by the International Swaps and Derivatives Association.
In line with its standard procedure for new markets, ISDA began by compiling all the documentation used by the market - the long form definitions - in 1998. The idea was to see which definitions made most sense in practice before condensing them into a set of shorter standards which could become the market standard.
In the event, the long form definitions were stress tested in the most dramatic way possible. Russia's moratorium on its domestic bond obligations triggered the greatest volume of payouts the infant market had seen. Although this default led to a certain amount of legal disputes, by and large the events provided positive evidence that the market could work as it was meant to.
As a result, when the short form ISDA definitions were published a year later, they were supported by established market practice. This documentation, now used as the basis for the vast majority of credit swaps, has pushed credit derivative volumes to new heights.
"The significance of documentation cannot be overstated," says Walter Womersley, assistant director in the structured products group at Dresdner Kleinwort Benson in London. "The ISDA short form documentation gave an immense boost to the credit derivatives market."
Gauging the size of the credit derivatives market is a far from exact science, given its over-the-counter nature. Only two sources can be relied upon to give any clear indication of volume trends, and both have serious limitations.
The US bank regulator, the Office of the Comptroller of the Currency, collects data on the size of banks' credit derivative books as part of its efforts to monitor all derivative exposures. However, these figures tell only part of the story, because they include only those banks regulated by the OCC - that is, the onshore arms of US banks.
But they clearly show that the credit derivative market has grown rapidly and consistently over the last four years. According to the OCC, notional volumes traded rose from $55bn in the fourth quarter of 1997 to $362bn in the second quarter of 2000.
The other source of data confirms this general trend. The British Bankers' Association estimates the size and structure of the market based on occasional surveys of participants. According to the BBA, notional volumes outstanding increased from $180bn in 1997 to $586bn in 1999.
The BBA's figures also shed some light on how the market is being used. As might be expected, the biggest buyers of protection - that is, sellers of credit risk - are banks, the traditional originators and holders of corporate credit. Banks accounted for 63% of risk supply in 1999, with securities firms making up much of the rest.
Banks primarily use credit derivatives to manage their credit books. Using credit swaps, they can hedge risk concentrations, improve the diversity of their exposure and reduce the amount of capital they need to allocate to their portfolios.
This is the classic role of credit derivatives. But banks can use them in other ways as well - for example, to hedge exposure taken on by their debt underwriting arms.
Trading volumes on a particular name in the credit swaps market tend to rise shortly before a large bond is issued, presumably because underwriters are hedging any positions they may be left with if the bond issue fails to sell.
As long as most of the world's credit remains tied up in the banking system, commercial banks are likely to remain the most important buyers of credit protection. But credit derivative bankers are enthusiastic about other sectors, too.
Corporates, for example, have recently been touted as natural users of the product. Suppliers of telecoms equipment, for example, may worry about their heavy exposure to a small group of customers in an increasingly leveraged sector.
Credit derivatives can be used in mergers and acquisitions. When British American Tobacco bought a Mexican company, Empresa de Moderna, in the mid-1990s, it chose to pay for the acquisition with promissory notes. The previous owners of the Mexican company wanted to hedge their holding of BAT debt and did so by buying credit swap protection from JP Morgan.
Credit derivative specialists are keen to talk up these alternative protection buyers because the market has always been plagued by an undersupply of credit.
"There has typically been more demand for exposure in the credit derivatives market than supply," says Frost at JP Morgan. "The main constraint on market growth is that some banks are not yet comfortable with the idea of paying a premium to hedge what they see as perfectly good assets. It took JP Morgan 157 years to reach the conclusion that this was a rational thing to do so we should not be surprised if it takes some banks several years to reach that point."
Credit swaps and basket trades
The basic building block of the credit derivative market is the credit swap. According to the BBA, credit default swaps accounted for 52% of notional volumes in 1997 and 38% in 1999.
However, these figures understate the true importance of credit swaps. Many are simple contracts referenced to a single credit. But in addition to these single name trades, credit swaps form the basis of many more complex structures.
Credit swaps have largely eclipsed another structure, the total return swap, that enjoyed some popularity in the early days of the market, particularly for emerging market credits.
These instruments, which swap a floating payment for the total return of a reference asset (that is, its mark to market performance), failed to gain much liquidity and there is practically no two way market making in these structures today. Total return swaps were said by the BBA to represent 16% of the credit derivative market in 1997 but only 11% in 1999.
The hallmark of credit derivatives is that credit can be converted into whatever format appeals to an investor or hedger. The role of a market maker is not simply to make two way prices on standard products such as single name credit swaps, but to repackage and structure credit in as many different ways as possible.
"The credit derivatives market is about transforming credit," says Robert Heathcote, head of European credit derivatives at Goldman Sachs in London. "It involves sourcing, warehousing and distributing credit risk."
One of the most valuable ways a bank can intermediate in this market is to transform an unfunded credit swap exposure into a security which can be bought by a traditional fixed income investor.
According to the BBA survey, 14% of credit derivative volumes in 1997 and 10% in 1999 consisted of credit linked notes. However, this estimate may well understate the amount of credit repackaging which takes place.
Market makers can also transform credit derivatives into undrawn loan facilities, known as synthetic revolvers. This form of credit investing is popular with many banks because it attracts a 0% regulatory capital weighting.
For insurance companies, unfunded credit exposure can be documented as a standard reinsurance contract.
Dealers can access this market by using insurance transformers. These are typically insurance companies or special purpose vehicles (SPVs) in Bermuda which enter into simultaneous credit swaps and credit insurance contracts.
Some innovations in the credit derivative market have so far failed to take off in a big way.
There have been several efforts to develop a market for credit spread options - instruments which allow the holder of a bond to hedge against its spread rising above a certain level. However, according to the BBA survey, credit spread products accounted for 13% of volumes in 1997 but only 5% of the market in 1999.
Basket trades are one of the most controversial areas of the credit derivatives market, with a reputation for being complex instruments which are frequently mispriced. Perhaps as a result, they have yet to become a large part of the market. The BBA calculated that only 5% of the market consisted of basket trades of one sort or another in 1997, and only 6% in 1999.
In fact, the term basket trade covers a variety of structures. "Basket trades can be either quite simple or relatively complex," says Womersley at Dresdner. "Someone can buy protection on a basket of credits so that if one credit defaults there is a payout and the credit default swap continues on the reduced basket.
"[On the other hand,] first-to-default baskets range in complexity and are typically more difficult to price."
First-to-default baskets are the structures which have attracted controversy. Buyers pay for protection on a portfolio of assets, but compensation payments are only triggered by the first default in the pool.
The appeal for protection buyers is that the structure provides a near hedge on the entire basket at a cheaper price than a series of single name credit swaps.
Protection sellers have found these structures very difficult to include in portfolio performance models, but some have been willing to write the swaps because they can treat them as single exposures for regulatory purposes.
The great benefit that basket trades provide is economy of scale.
Recently they have been overshadowed by more sophisticated portfolio swaps.
But these not suitable for all protection buyers. So smaller basket trades, typically consisting of five to 10 names and with relatively short maturities of three years, continue to play a niche role in the market.
Investment banks pile in
If data on the size of the credit derivative market is patchy and unreliable, estimates of intermediaries' market shares are almost non-existent.
There is a small core of no more than 10 banks which are active market makers for a large number of credits, and a much larger number of banks which do not attempt to cover the whole market but trade in certain niches.
As well as banks, the second group includes a few non-bank institutions, notably Swiss Re New Markets, as well as interdealer brokers such as Garban Intercapital which try to take as little net exposure as possible.
There is not much doubt which is the biggest market maker. The OCC's figures suggest that JP Morgan accounted for nearly 70% of all bank credit derivative exposure in June 2000. The figure is almost certainly too high, but most participants agree that Morgan is the dominant player.
With its risk management expertise and strong presence in other over-the-counter (OTC) derivative products, JP Morgan was one of the first banks to commit significant resources to the market. But as volumes have grown, plenty of others have beefed up their capabilities.
Morgan's biggest competitor may be Deutsche Bank. The German institution had the misfortune to lose its global head of credit derivatives, the highly regarded Ron Tanemura, to Goldman Sachs in March 2000. But it retains a large global credit derivatives team, which also covers such products as MTNs and repackagings.
Deutsche has been hiring aggressively in recent months, taking a number of senior structurers and traders from other banks as well as from law firms and rating agencies.
Credit derivatives is a business which requires significant capital commitment, and it is no coincidence that many of the biggest players are commercial banks or the investment banking arms of universal banks. They include Credit Suisse First Boston, Bank of America, Citigroup, UBS Warburg, CIBC and Royal Bank of Canada.
With the exception of Morgan Stanley Dean Witter, which particularly in New York is an important market maker, pure investment banks have so far been less prominent in credit derivatives than in other credit products. Merrill Lynch and Goldman Sachs have had little involvement until recently. But both are now stepping up their efforts.
Goldman Sachs claims to have hired no less than 50 new people on the trading side this year, while Merrill Lynch's London office poached a structuring and trading team headed by Herman Watzinger from Schroder Salomon Smith Barney in February 2000.
The use of credit derivatives in securitisation has given the OTC product a new lease of life, and encouraged several banks to move into credit derivatives from a base in the ABS market.
Thus, firms such as ABN Amro, Lehman Brothers and WestLB have bankers working on synthetic securitisation and portfolio swaps as part of their securitisation teams.
The cash/swap arbitrage
As with any derivative product, part of the attraction of credit swaps is the possibility they afford for arbitrage trading between the derivative market and the underlying cash market.
The price relationship between credit swaps and cash bonds is constantly changing and far from straightforward.
The credit default swap premium for a given name can be compared to the same credit's spread over government bonds in the bond market. Both figures are intended to capture the credit's riskiness versus a 'risk free' benchmark.
But more often, asset swaps are used as the benchmark for comparing cash market spreads with credit swap spreads. Swaps are increasingly the credit benchmark for the capital markets, since the government curve prices in other factors as well as risk, such as the extra liquidity of government bonds and tax benefits in some countries, notably the US.
Traditionally, credit swaps have been priced at a premium to bond spreads, partly because the product is new and the cash market is more liquid. But there are also technical differences between the markets which should affect their relative pricing.
If a cash bond defaults, the recovery rate may be unpredictable, but at least the bondholder knows where he or she stands.
The protection seller in a credit swap contract may assume an extra risk. The remedy in the case of default may be to deliver to the protection seller some obligation of the reference credit, which could be a bond, a loan or some other form of borrowing.
"In theory, the price of a credit default swap should be wider than that of an asset swap because of the uncertainty about which assets will be delivered into the contract," says Walter Womersley, assistant director of global structured products at Dresdner Kleinwort Benson in London.
Protection sellers should, theoretically, demand a premium to compensate them for the risk that they might be delivered an asset with low recovery values.
However, in the last year credit swap spreads have tightened sharply relative to bond spreads, particularly for highly rated credits.
"In the past year there has been massive demand for credit in synthetic form which has outstripped supply," says Womersley. "As a result, we have seen some credit default swaps priced on a negative basis to the cash market."
For high yield names, credit swap spreads tend to be much wider than bond spreads - partly because protection sellers are reluctant to embrace lower rated credits, and partly because high yield bond underwriters are eager to buy protection on their inventory.
"The market continues to demand a premium for emerging market names where they perceive real risk," says another banker. "But for a credit such as Deutsche Bank, where investors do not believe a credit event will happen, they are prepared to accept a low swap premium."
Meanwhile, the theoretical basis between credit swaps and the cash markets widens out again at the very top of the credit spectrum. The most liquid triple-A bonds can trade through Libor, but a credit default swap premium cannot, of course, be less than zero.
"Across the credit spectrum the basis between credit swap prices and bond spreads has narrowed in the past couple of years," says Tim Frost, European head of credit derivatives trading at JP Morgan in London.
"The basis is narrowest in the middle of the credit curve. Some credits have even traded through bond prices in the credit swaps market at various times."
Investment banks pile in
Portfolio swaps are often seen as the most dynamic area of the credit derivatives sector. But in this fast moving market plenty of other developments are taking place behind the scenes.
A lot of innovation focuses on structuring standard credit swaps. Various kinds of derivatives can be embedded to eliminate certain undesirable risks or uncertainties, such as unpredictable recovery rates on defaulted assets.
Most players foresee continuing steady growth in credit derivative volumes and ever more sophistication in structuring.
But some observers still harbour worries about the fundamental basis of the market, and question whether institutions can really hedge credit risk effectively.
The language of most credit swap contracts leaves plenty of room for dispute about whether or not a credit event has taken place.
For example, one standard credit event is debt restructuring - but not all changes to the terms of a loan or bond count as a restructuring. According to ISDA definitions, a restructuring only takes place if the terms of an asset are changed as a result of a significant deterioration of the credit. But "significant deterioration" is not defined in the ISDA rule book.
Earlier this year, US finance company Conseco restructured some of its bank debt, triggering credit protection contracts on the name.
The event brought the controversy to a head. Habitual protection sellers, typically insurance companies, argue that Conseco exemplifies a company whose credit is not damaged, but which will simply be paying its debts according to a different schedule. On the other end of the trade, bank loan portfolio managers claimed that this was exactly the kind of event they wished to protect themselves against.
There is now a rift in the market - many protection sellers want the standard contract terms on which prices are quoted to exclude restructuring, while many hedgers want it included. It is harder now for dealers to match trades, and they could potentially be left holding a basis risk between contracts on slightly different terms.
There is still an appetite for selling protection that covers restructuring, but often at a higher price, and the dispute has slowed trading volume.
Such uncertainties are frequently cited as a deterrent to new participants in the market.
Although a number of defaults, particularly in emerging markets, have triggered credit derivative payouts, the market is still too young to have been tested by a serious credit crisis in a core sector. When credit events have occurred - such as Russia's domestic debt moratorium in 1998 - there have been significant amounts of litigation.
Does this mean that the credit derivatives market is failing to work as it should?
"Where there is default there will always be litigation," responds Frost at JP Morgan. "In that respect the credit swaps market will be no different from the bond market. But that does not mean that credit swaps are not providing a valuable economic function." *
|Off-balance-sheet credit derivative contracts of US regulated banks, June 2000|
|Bank of America||27,696||7.7|
|Bank of New York||1,725||0.5|
|First Union National Bank||1,600||0.4|
|Source: Office of the Comptroller of the Currency|