You know a market is becoming significant when the regulators start to signal alarm. Last month, the Securities & Futures Authority, which supervises investment banking and broking in the UK, expressed concern about credit derivatives. Last November the Bank of England issued a discussion paper on the same subject.
No doubt both had in mind last October's survey of credit derivatives by the British Bankers Association. It confirmed that outstanding credit derivatives amount to just $20 billion, but predicted that London would be the centre of a $100 billion market by 2000, partly because of "its pragmatic regulatory environment".
For the uninitiated keen to tap a new market, there are legal complexities to grasp. First, the term credit derivative covers four different categories:
- credit spread products (CSPs), where the payout is triggered by a change in the spread of a debtor loan instrument (the reference obligation or RO);
- total rate of return swaps (TRORS), where a swap-type payment is made (eg, periodic payment of a fixed sum or Libor-based amount), but any depreciation in the value of the RO (or basket of them) is also paid in return for any income and appreciation on the RO;
- credit default products (CDPs) where, unlike a CSP or TRORS, the payout depends solely on a credit event, defined as the occurrence of a payment default by borrower or issuer (ie, the reference entity) or its insolvency; and
- credit-linked notes (CLNs) which are securitized credit derivatives and tend to be based on the CDP mechanism, so return to the holder depends partly on whether a credit event occurs.
To a greater or lesser extent all of these shift the credit exposure to a single reference entity or a group of them.
"There is a world of difference between a credit derivative on a publicly traded instrument like a bond and one on a privately traded instrument such as a loan," says Claude Brown, a derivatives specialist at legal firm Clifford Chance. "Credit derivatives traders come from the public market but there is a link to the private loan-trading market with analogous products. This produces a spectrum of instruments which do similar, but not identical, things."
Some credit derivatives mimic established legal instruments but can have different consequences. For example, TRORS can look like synthetic repos and CDPs like risk sub-participations. It may be attractive to describe a CDP as a "guarantee" for legal, regulatory or marketing reasons but it may not function or be treated as a guarantee (with the protections it affords).
Equally, calling it a guarantee may, in certain jurisdictions, import legal consequences which cannot be excluded by contract. "The interchangeable use of terminology can lead to a misplaced understanding of the relative legal and economic consequences," warns Brown.
Because the documentation is not settled - the International Swaps & Derivatives Association (Isda) is working on a standard confirmation for CDPs - it pays to get it right.
Brown says: "In using a credit derivative to hedge a bond or loan, the hedger is effectively employing the terms of one document to protect himself against a breach of the terms of the other, so you need to avoid documentary asymmetry."
For instance, the higher the borrower/issuer's credit standing, the more likely it is to have pushed for a relaxation of the events of default in the RO: there can be a difference in triggers between different issuers and even between different instruments of the same issuer.
There have been rapid developments in documentation over the last three years. If you or your counterparty are not market regulars, make sure the documentation you are using is up to date, incorporating the latest legal thinking.
Be careful with credit-linked notes and the customization of medium-term notes to include credit-derivative wording. These deals tend to be private so it may be more difficult to establish the market norm for documentation.
There can be definitional problems. In the case of public instruments it is easy to define a credit event by way of publicly available information; in a private context it can be difficult to define the point at which a credit event is triggered. By their nature, credit derivatives referenced against a borrower or its indebtedness will act as an indicator of its declining creditworthiness.
This raises questions of bank confidentiality which may be alien to a derivatives trader. To what extent can a bank pass on information about a borrower, acquired in a lending relationship, to a counterparty under a credit derivative? Depending on the jurisdiction, to do so may be a breach of a banker's duty of confidentiality. This could become an issue if the borrower's commercial competitors are in the market fishing for this sort of information.
Equally, it can be off-putting for traders used to the private market to have to weigh up questions of insider dealing. Unlisted private instruments are generally not caught by the EU insider dealing legislation, which is tightly worded. But this is not true of all jurisdictions outside the EU where dealings in other types of instruments and related derivatives may be caught.
The different legal treatment between jurisdictions can provide legal arbitrage opportunities. It can also cause regulatory problems. Credit derivatives risk straying into the field of insurance, which traders familiar with interest rate and currency swaps may find difficult to grasp. A credit derivative which enables a lender to lay off the borrower's credit risk may have that effect.
But there is no easy way of knowing since, under English law, there is no statutory definition of a contract of insurance. Carrying on the business of insurance is heavily regulated in the UK.
It is licensed by the Department of Trade & Industry and the regulatory treatment is different from that of banks by the Bank of England. You cannot lightly run off and get a licence. But if a credit derivative is insurance, the seller may be required to repay any "premium" and may also be committing a criminal offence.
Another regulatory problem area is gaming. In the UK gaming or wagering contracts are unenforceable as a matter of public policy. This used to be a concern with swaps. But the Financial Services Act (section 63) exempts the making or performance of a contract which constitutes "dealing" in an "investment" from being gaming or wagering. That should cover most credit derivatives on public instruments. But, for example, a bilateral loan is not an "investment" so a related credit derivative may not fall within section 63.