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It pays to get credit derivatives right

The use of credit derivatives is set to expand dramatically. Christopher Stoakes explains some of the legal pitfalls.

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.

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