Credit derivatives: Maturity of hot new market faces its sternest test
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Credit derivatives: Maturity of hot new market faces its sternest test

Credit derivatives are the hottest area in the global fixed-income market. They promise to transform the entire credit world, by bringing greater liquidity and transparency. But the dramatic worsening in credit, exemplified by Enron's collapse, will severely test the market. Some fear the explosive growth has stored up unseen problems. Regulators fret that risks may have been transferred out of banking and into less sophisticated institutions.

The credit derivatives business is no stranger to shocks. Since its emergence in 1996, it has already lived through three major credit market dislocations - triggered by the Asian currency crisis in 1997, Russia's debt default in 1998 and the collapse of Long Term Capital Management in 1999.

Now this youthful market faces the greatest test yet - proving its worth as a tool for mitigating and transferring credit risk at a time of dramatic credit deterioration and the nightmare scenario of the collapse of the energy trader Enron.

The financial world is not short of people who believe that credit derivatives will change the entire way in which credit is priced, traded, structured, sold and managed. Most of these are highly skilled, highly motivated investment bankers - and that is what they are paid to think and say.

Nor is it short, either, of people who are nervous about credit derivatives - and, worryingly, for the bankers, at least some of these are central bank regulators and supervisory authorities that have the capacity to rein back the market's explosive growth.

A tough market challenge

These two groups might not usually concur on much. But they do agree that the credit derivatives market is about to undergo a rigorous examination of its ability to function in a tough credit market.

Will these products actually work when they need to work? Where is the credit risk ending up? Do investors and other end users understand the risk they are taking on? And what are the broader risks to the banking system and the broader economy?

Credit derivatives are one of the fastest-growing and most profitable sectors of the global fixed-income business. They could redefine the credit world - bringing liquidity to illiquid credit markets, creating credit price transparency and facilitating the design of virtually any type of credit exposure that investors, companies, banks and financial intermediaries want.

"It is a real revolution," says Farid Amellal, global head of credit derivatives at BNP Paribas. "It is the biggest change to hit the capital markets since the interest rate swaps market 20 years ago. But, unlike interest rate and equity derivatives, this is happening at a time when technology is already well advanced, so the growth will be much more rapid. Instead of taking 15 years, this could happen in the next three to four years."

Like many other market professionals involved in the development of the swap markets in the 1980s and 1990s, Robert Heathcote, managing director at Goldman Sachs, foresees huge growth. "If you look at the interest rate swap market, it took a while to grow but it is now more than two and a half times the size of the $18 trillion global government bond market," he says. "The global credit market is about $30 trillion, of which credit derivatives account for about 3% to 4%. This is absolutely tiny in comparison to what could happen."

Dominated since its inception by a handful of banks and securities firms, the market is broadening fast as new intermediaries join the party, new investors venture into the market and new products are structured to suit a wide variety of client risk requirements.

There are two main components of the market - credit default swaps (either on single names or reference assets, or on baskets of credits) and collateralized debt obligations (CDOs). Both show dramatic growth in volume and diversity as an ever wider range of users is attracted by the opportunities to transfer, hedge, trade, manage or invest in credit risk.

But further growth may depend on how robustly these instruments perform in the next few months. In the current climate of credit deterioration, the pressure is on. Losses are mounting and disputes are brewing.

And the consequences of the downturn for investors, insurance companies, banks and intermediaries could dictate whether the market realizes its potential, or is thrown off course by a sudden, severe shock to the system.

Goldman's Heathcote believes that there is a fundamental shift in the credit derivatives market. There is, he says, a move away from a market dominated by banks transferring risks from their balance sheets through default swaps and other credit derivatives (largely with other banks and insurance companies) to one in which all client types are looking to participate in credit in ways that were not previously possible.

"Because the credit markets are fundamentally inefficient, this creates relative-value opportunities for our clients, both as hedgers and investors," he says. "Coupled with volatile credit markets and a set of tools to transfer and transform credit risk, providing client solutions across products, markets and credit types, this creates the opportunity for enormous growth."

Growth opportunities

To date use of credit derivatives by commercial and retail banks as a tool for managing credit risk exposure has been concentrated among a few large institutions. According to Scott Eaton, managing director of global credit derivatives at Deutsche Bank, of the 400 banks in the US that use derivatives, only 19 use credit derivatives.

Data from the Office of the Comptroller of the Currency show that only the largest US banks use credit derivatives on any scale - either as intermediaries or as purchasers of protection to hedge risks on their loan books.

According to the OCC data, the notional credit derivatives exposures of one bank - JPMorgan Chase - comprised 64% ($227 billion) of the aggregate for all 400 US banks and trust companies at end-March 2001.

Outside of three banks - JPMorgan Chase, Citigroup and Bank of America - the notional exposures of the remaining 397 US banks was just $18.4 billion. According to some sources, JPMorgan, Deutsche Bank and Citigroup account for some 90% of credit derivatives activity in the US.

"If we just limit it to the banking sector, think of the growth," says Eaton. "But now we are seeing corporates getting interested in the market and asset managers moving into CDOs, and the growth is becoming explosive."

Tim Frost, of JPMorgan's credit derivatives business in London, is in no doubt that bank usage will grow as rating agencies and equity markets increasingly focus on credit risk management in banking institutions.

Frost points to a recent seminar for bank equity analysts held by JPMorgan, attended by 47 front-line analysts - at least some of whom were sceptical about the quality of loan information coming from banks.

"The analysts were all saying: 'Tell us about risk transfer. Where does the risk end up?'," says Frost. "The message we took from that was clear: if your institution is managing credit risk actively, it is good for your share price."

That may well be the case. But the vast majority of potential bank hedgers have taken the view that credit derivatives are relatively expensive compared with traditional forms of exposure management such as diversification and credit control.

Default swaps, the original credit derivative instrument, were traditionally an inter-dealer market, with banks buying credit protection from sellers such as other banks and insurance companies.

Now the growth is being driven off the back of the portfolio market, which involves investment banks structuring credit portfolios for investors. "The major influences on the default swap market are investment banks buying protection, and hedge funds hedging out their convertible bond exposures," says a London-based banker who has been involved in recent market surveys.

Similarly, CDO business has shifted from its origins as a way in which banks could package loans and sell them on to investors - typified by JPMorgan's groundbreaking Bistro programme - to become an investor-driven market where intermediaries structure credit portfolios in response to specific investor demand.

Arne Groes, head of credit derivatives at ABN Amro, says the huge recent growth in synthetic CDO transactions - where outstandings are now around $250 billion - points to a fundamental shift: from being led by the requirements of issuers, or hedgers, to being driven by investors.

"The biggest players in the credit derivatives market have so far been banks, but that is changing," Groes says. "Investment banks have great client coverage and are transaction-led. Investment banks are driven by arbitrage, banks by balance sheet.

"The market is becoming investor-driven, based on reverse enquiry as investment banks structure up products to suit specific investor demand. That is the side of the market that is taking off as user acceptance of the market has grown, and one of the attractions of CDOs is that they look cheap compared with other credit products."

With so many drivers converging at once, the intermediaries know they are on to a good thing. Investment bankers need no educating in how to market a hot product and they are pushing the credit derivatives business for all it is worth.

"Credit derivatives: the future of fixed income", trumpets a recent presentation pack from JPMorgan - which, together with Deutsche Bank and Citigroup, is a pioneer of the credit derivatives business and still occupies a dominant role.

In the same vein, "Credit derivatives: their time has come," blazons an equity research report by Goldman Sachs's brokerage and asset management analysts - who predict, among other things, that current revenues of around $1.5 billion to $2 billion to credit derivatives intermediaries could grow to $9 billion in the next five to seven years.

So how will the market for these relatively novel instruments come through this major test of its maturity and robustness? Corporate credit quality is crashing on all sides, credit spreads are exhibiting severe volatility, supposedly safe CDO structures are suffering rating downgrades, credit events are coming thick and fast, derivative contracts are becoming subject to intense scrutiny and participants on all sides are being exposed to risks that they might not have expected.

The malaise in corporate credit markets that began in the final quarter of 2000 would arguably have been enough of a test for all credit products even without the September 11 attacks. But the credit migration and deterioration already under way has accelerated dramatically since then; nobody can be sure where the next credit shock will come from, but they know it will not be long coming.

For the credit derivatives business in Europe, the defaults of airline Swissair and UK rail infrastructure company Railtrack in quick succession have come as a sudden wake-up call. While defaults and restructurings have been relatively common in the US, in Europe they have been virtually unknown.

The bankruptcies of Swissair and Railtrack are not the only issues to have exercised dealers' and lawyers' minds in recent weeks. There is also the potentially nightmarish question of Argentina's protracted debt restructuring, which is causing widespread uncertainty over all default contracts relating to the largest issuer of emerging-market debt.

And there is deep apprehension over the future of US energy company Enron. Together with its Enron Credit operation this was not just the most high-profile corporate user of credit derivatives but also an active market trader in its own right, as well as being the reference asset for numerous default swaps and a component of many CDO portfolios.

According to one dealer, eight of the top 10 credit derivative intermediaries traded with Enron Credit. And most investors will have had Enron in at least one of their portfolios. If the market needs a real test of its robustness, the Enron situation may well provide it.

"It is a huge problem," says one dealer. "It's a real can of worms. Nobody has been trading with them and everyone is trying to work out what to do next."

But it is the insolvency of two well-known corporates - which had a large volume of derivatives contracts outstanding (around $1 billion in the case of Railtrack), and which seemed to enjoy quasi-government backing - that has focused minds.

Uppermost among the worries are the unpredictability of credit events, the infrastructure of the still nascent credit derivatives markets, the robustness of the contracts on which the market depends and the fact that some parties are going to find themselves taking some painful losses.

In short, people are asking whether the market is mature enough to deal with what may be about to happen - a wave of credit events, challenging the documentation and legal framework of the market, creating disputes between dealers and users and unsettling the regulators at a time when decisions about new bank capital proposals under the Basle accord are reaching a key point.

Advocates of the credit derivatives business are in no doubt that the current credit collapse will finally drive home to the financial and corporate communities the need to manage and diversify credit risk.

"Bear markets are good for credit derivatives," says Frost at JPMorgan. "Credit derivatives are a force for transparency in the credit markets, and that's healthy. In the current downturn the credit market needs a robust credit derivatives market more than ever, Sceptical users are turning to the credit derivative market in adversity, and our view is that the credit derivatives market has reached maturity - in the nick of time."

He points to the execution between JP Morgan and Morgan Stanley of the first credit derivative master agreement in Europe at the end of November as a major step forward in the commoditisation and standardisation of the market.

The agreement allows the execution of credit swap trades between the two parties using a standard one-page confirmation form.

The two firms believe it will enable trades to be confirmed faster, reduce the strain on banks' operational infrastructure, increase market liquidity and virtually eliminate documentation risk.

But Frost also concedes that there are potential problems as the market grows. "When a market is growing as quickly as this one, there is a temptation to use systems that are not really designed for credit derivatives, and deploy individuals with little credit derivative experience," he says. "This could yield a bitter harvest."

He adds: "All markets experience growth problems, and the credit derivative market is no different. But it is important that losses associated with corporate defaults aren't confused with so-called 'problems with credit derivatives'."

Consultants say that many banks, for instance, have been inputting credit derivatives into IT systems designed for interest rate derivatives - systems that cannot properly trigger alerts and indications of imminent, hefty exposures. The potential for nasty surprises on the technology front alone is alarming.

Bankers see potential problems, too. "Now that credit events are becoming more frequent, how will that affect the market?" asks Groes at ABN Amro. "We are shaking the tree now; let's see what falls out. We've had some credit events, and we will no doubt have many more. If investors have lost money, they won't come back to the market if they took risks that they were not aware of. And, if banks that have bought protection don't get covered, there will be repercussions."

Already there is talk in the market that investors that have taken substantial losses on aggressively priced CDO transactions issued in 1998/99 - some of which have suffered far greater than expected deterioration in rating and portfolio quality - are unhappy about the way the product has performed. More of a concern, perhaps, is that they are also said to be unhappy about the way in which the instruments, and the potential risks, were explained to them by the banks that sold them.

Bankers sense a similarity with the problems in structured interest rate products in 1994 when the fixed-income markets blew up. Then a number of investors took big hits on structured notes and many walked away from the market altogether.

But there are also ominous echoes of other high-profile derivatives disputes in the 1990s - such as those involving Procter&Gamble, Gibson's Greetings Cards and Orange County - and that is exactly what the promoters of the credit derivatives industry are most anxious to avoid.

It is the very last thing that regulators want to hear, too. For all their growing acceptance of derivatives as a risk-management tool in recent years, many are still nervous of "the d-word", as one banker puts it.

Tony Clifford, partner in the banking and capital markets practice at consultancy Ernst&Young, is in no doubt that a significant deterioration in the credit markets could trigger any number of problems - potentially leading to high-profile litigation and damaging publicity.

"The worry is what happens if there is a major deterioration in the credit market," Clifford says. "It is quite possible that the overall effect of credit derivatives will be to make any significant credit deterioration rather worse."

He adds: "If these things go wrong, you may have investors and companies arguing that they didn't understand what they were doing, or that they were acting ultra vires; you may have insurance companies finding ways of wriggling out of their contracts; and you may have people claiming that they were mis-sold products by the financial services industry."

This may be an extreme view. But, spoken or unspoken, it is a fear that lurks in the minds of everyone involved in the business - intermediaries, users, regulators, rating agencies and consultants.

"As with any developing market, there may have been abuse of the product," says Amellal at BNP Paribas. "It is possible that, in the last few years, some investors used the product in an inappropriate way."

He adds: "We have been hearing in the street that some people are not happy with the way that some of their CDO investments have performed in the last 12 to 18 months, and that they believe that the risks were not fully explained to them."

But Amellal, and most of his counterparts at the leading credit derivatives houses, believes that intermediaries - scarred by high-profile lawsuits involving Procter&Gamble and Orange County - have been at pains to ensure that products and risks are fully explained to clients, and that they only deal with sophisticated counterparties who understand what they are doing.

"It is the duty of banks to give information to investors," he says. "It is a basic marketing discipline to tell investors what they are exposed to, and the time to give that information is before the event, not after it."

He adds: "If the banks made the mistake of not explaining the risks to clients, then there will be problems. But, if people take losses on derivatives today, it is unlikely to be because financial services firms have been mis-selling.

"I don't think we can go back into P&G or Orange County territory again. The derivatives market is much more mature than it was 10 years ago, and in terms of the use of credit derivatives people are much more mature."

That may well be true. By far the biggest players in the credit derivatives market since its inception in the late 1990s have been the largest banks and securities firms - both as buyers of protection and as intermediaries - and the largest and most sophisticated reinsurance companies and property and casualty insurers as sellers of protection.

But in the past year or so the market has also seen the entrance of less-sophisticated players - both as intermediaries and as end users - such as second-tier banks, regional banks, life insurance companies and pension funds. And that is where the problems may arise.

Clifford at Ernst&Young believes that, with a deterioration in the credit market, a number of hidden problems will come to the surface. Among these he cites ambiguous or undefined contract terms, problems due to correlation in the likelihood of default between the reference assets and the writers of protection - in other words, just as the reference asset defaults, the protection seller also defaults - and concentration of risk in portfolios.

"We have seen examples of all these problems and I am concerned that many more are lying dormant," he says. "Most of the bigger, better organizations do take pains to minimize correlation risk, but secondary players may have been a good deal less attentive. "

And he adds: "I would be pleased if we did not see any disputes breaking out between dealers and investors, but I would be nervous as well."

A further risk is that banks have bought protection from insurance companies that may be slow in compensating those buyers if there is any doubt as to the validity of the claims.

So far any potential disputes have been settled quickly and relatively amicably. But there were problems over the Conseco restructuring in the US at the end of last year. There were problems over the Railtrack bankruptcy earlier this year. And it is a racing certainty that the frequency of problems between buyers, sellers and dealers is set to increase, not decrease, in the months ahead.

"Insurance companies are less likely to say they didn't understand what they were doing," says one UK banking consultant, "because the firms in this game - the reinsurers and monolines - are pretty sophisticated. But it wouldn't surprise me if there were some problems over the wording of contracts, nor would it greatly surprise me if some people had deliberately made the wording tricky."

Credit derivatives are all about the transfer of risk - among banks, through the traditional inter-dealer market in credit default swaps, and increasingly from the banking sector to the non-banking sector. This is done through portfolio transactions where the risk is divided up into tranches and sold to different classes of end investor.

As a result bank regulators and increasingly the insurance and investment systems, are stepping up their information gathering to get a better feel for the scale of the credit derivatives business itself, but also to get a handle on the cross-market transfer risk that is involved.

The collective view of regulators is hard to assess. The Bank for International Settlements, which is known to be broadly in favour of derivatives, has a working group looking at credit risk transfer. So does the International Association of Insurance Supervisors, which indicates the extent to which risk transfer has permeated the insurance industry. But at least some central bank regulators are nervous about derivatives in general.

Intermediaries are aware of the importance of bringing regulators up to speed as quickly as possible. "Credit derivatives are designed to mitigate and transfer risk from one set of investors to another," says Groes at ABN Amro. "It is not the job of regulators to stifle innovation, but it is part of our job to make them as comfortable as they need to be with this business."

Of greatest comfort to market professionals is the attitude of the Bank of England, which published a widely praised report on the credit derivatives market in its July 2001 Financial Stability Review. From this it is clear that the Bank supports the development of credit derivatives as part of the development of a wider credit risk transfer market. But it is also clear that it has concerns.

"Although credit derivatives are probably more likely to disperse risk, there is also the possibility that they could deliberately or inadvertently concentrate it," the report's author, David Rule of the G10 Financial Surveillance Division, wrote.

"Separating the exposure to credit risk from the direct relationship with the borrower ... might make it more difficult for creditors, regulators and the monetary authorities to assess the actual credit exposures of banks and of the banking system as a whole."

But, the report concludes: "On balance, the range of new credit risk transfer markets has the potential over time to increase the overall robustness of the global financial system."

Market professionals believe that the report has given an important vote of confidence to the market at a crucial time. Although it no longer has responsibility for bank regulation and supervision, the Bank's message that it believes credit risk transfer to be beneficial in terms of financial stability has been roundly welcomed.

But the Bank's financial surveillance division, and other regulators worldwide, also appear to be concerned that the reduction in systemic risk to the banking system does not simply result in a build-up of risk in other sectors.

One senior European bank executive comments: "There are three main worries: where the risk is going; whether the people who are buying it really understand what they are doing; and whether they are prepared to transfer funds into the banking system when an event occurs. It is legitimate for the regulators to ask whether the banking system is really transferring the risk."

Jonathan Davies, head of global credit derivatives at consultants PricewaterhouseCoopers and one of the authors of the firm's credit derivatives guide, The Financial Jungle, believes that operational risk is a greater worry to regulators than systemic risk.

"Every regulator is looking very closely at the credit derivatives area. They know how big this business could, and probably will, become," he says. "The opportunities are massive - and the intermediaries are banging the drum, saying that everyone needs to do it, that it is essential from a risk-management perspective. But, at the end of the day, there's a significant amount of money to be made in this market. Traders can unlock debt portfolios and transfer the risk to a new client base, making a significant margin in the process."

As new entrants pour into the market, and as new applications change the dynamics of the credit derivatives business, there is increasing focus on whether banks and securities firms have the technology, people and risk-management systems to cope with burgeoning volumes and rapid new product development.

"The regulators are also very concerned about the operational risks of this business," says Davies. "The over-reliance of banks on spread sheets, the fact that you have inexperienced people and possibly inappropriate systems, the fact that there is a lot of manual processing - all this leads to a major operational risk."

He adds: "Banks need to alleviate these concerns by building up their systems and getting good, reliable information. It is not just a quick fix; it is a question of getting senior management to grasp that, unless institutions show that they are doing this and that they understand how to manage the risks, regulators are likely to remain nervous."

Andrew Tinney, global head of investment banking at consultants Andersen, believes that lack of expertise in technology and risk-management systems should be a worry. "Some investment banks don't have the technology expertise required to manage the risks," he remarks. "It may take an accident to happen before they discover what the hole in their system is."

Just as financial intermediaries have a vested interest in selling the merits of credit derivatives to their clients, financial consultants have an equal interest in selling the importance of risk-management systems and financial controls to their clients in the banking and securities sectors. After all, it is more than likely to be they who win the contracts to design and refine these systems.

But they have a more objective view of the market than the banks. PwC's Davies believes that regulators are also increasingly focusing on the fundamental question of where the risk is ending up. "This market is all about credit seepage - the movement of credit risk away from a banking environment to a non-banking environment," he says. "That is good for the banking environment because it reduces the systemic risk. But, if you don't know where the risk is, it is very difficult to control."

A senior executive at another London-based consultancy firm says: "The regulators are nervous about whether they have scoped the issue enough. It is not just a question of whether credit derivatives are good or bad. The bigger question is where are all the credit derivatives, where is the risk this time when the music stops?"

He adds: "It is difficult for anyone to know where all the risk is sitting, particularly if people are not aggregating risk, because there could be some very nasty correlations between market and credit risk that have not been anticipated.

That is why regulators are concerned - but more about what they don't know than what they do know." Credit derivatives professionals are in no doubt that their product, and the wider process of credit risk transfer, will mitigate the effects of a sustained and deep credit deterioration as far as the banking system is concerned.

But there are plenty of other ways in which banks could be exposed: through risk management failures, through protracted payment disputes, through litigation from disgruntled investors and through simple human error. And there is every possibility that, even if the banking system has laid off at least some credit risk this time round, it may only have succeeded in transferring it to the investment community - from where it could boomerang back onto the banks.

"One of the key questions is where is the loading in this recession?" says Julian Leake, risk technology expert at Andersen. "Banks had all the credit exposure last time round. This time the buy side has a much greater exposure. They are now wearing the risk and the banks aren't."

Banks and insurers: at cross-purposes?

Of all the non-banking institutions that have embraced the credit derivatives market, the most important by far are the insurance companies.

They are not just run-of-the-mill insurers. They are the big Bermuda-based and continental reinsurers such as Swiss Re, Ace and Centre Capital, and monoline financial guarantee groups such as Ambac Assurance.

Together with the major property and casualty insurers, these highly sophisticated risk-takers have become the most important group of protection sellers in the credit derivatives market after banks themselves. According to a British Bankers Association survey in 1999, insurance companies accounted for some 23% of all protection sold.

Their interest in this and other capital markets-related instruments, such as catastrophe bonds or weather derivatives, has been sparked by what is known in the insurance trade as ART - alternative risk transfer.

It has played a major part in providing a ready supply of protection for the default swap market - given that default swaps are, in essence, simply insurance contracts. But will it continue to do so at a time when the dynamics of the insurance industry are changing fast?

"The trend of moving into ART, and specifically into credit derivatives, started at a time in the property and casualty cycle when rates were extremely low, and sophisticated writers were looking around for other ways in which to risk their capital," says Peter Allen, the former head of ART at Lloyd's of London who recently joined Ernst&Young to lead the firm's ART consultancy practice.

"Now that rates have moved from the softest level in a generation to, within the space of just a few weeks, the hardest that I've seen in my working life, how will that change their propensity to write these instruments?"

Besides providing a new premium source at a time of low rates, credit derivatives also facilitate a regulatory capital arbitrage between the banking and insurance industries. But, as one insurance industry analyst puts it: "There is also the potential for pricing arbitrage between banks, who know how to price credit, and insurance companies, who don't".

No-one doubts that the reinsurers and monolines adopt a sophisticated approach to risk and its pricing. "These are big guys, with big balance sheets, and they know what they are doing," says one banker.

But there is concern that some less sophisticated insurance companies have also ventured into the market in the last year or so - just as the credit market started to turn sour. These participants, who are likely to use less sophisticated risk systems and pricing models and rely on traditional actuarial analysis of risk, may well be regretting their move.

"We are seeing polarization," says one investment banker. "At one end, there are a number of people who want to be in this business for the long term. They have invested the necessary resources in people and systems and, for them, the recent widening in credit spreads will only serve to fuel demand.

"But, at the other end, there are people who are not strategically committed and who never understood the market fully. The deterioration in the credit market is causing them real problems - both because their pricing models have been thrown into doubt and because their correlation assumptions are being challenged."

An insurance industry analyst says: "One of the major risks is that insurers are generally exposed in their business to correlations that are extremely low. But the correlations between bonds and equities are much higher, particularly in a downturn, and they may not have realized this."

There are fears that insurance companies that have been active investors in portfolio CDOs - where the concentration of risk may turn out to be much higher than they thought - could start to take big losses as rating quality slides and default rates soar.

But a bigger fear is over the documentation of credit derivative contracts and the protracted payout disputes that could result.

As credit events increase in frequency, so does the likelihood of differences between protection buyers, protection sellers and dealers as to what constitutes a credit event, when contracts are triggered, what reference assets are deliverable and how settlement should be effected.

And although the 1999 Definitions have made documentation easier and clearer, there is still huge potential for ambiguity - an area that insurance companies have long been expert in exploiting when it comes to paying out on insurance contracts.

Already there are signs that insurance companies are trying to tighten the definition of default on new contracts that they are writing, and there is growing concern that insurers will go to considerable lengths to avoid - or at least delay - paying out protection.

"People like to make out that, when it comes to credit derivatives, insurance companies will somehow not behave like insurance companies normally do," says a London-based lawyer. "That is wishful thinking, I'm afraid. The more claims there are, the more the insurance companies are likely to dispute them."

He adds: "There is a risk to the banking system that the payment of claims will not be as rapid as it needs to be. The whole process of validating claims will be intensive and, for contracts of liquidity, which is what credit derivatives basically are, that is not an encouraging prospect."

A consensus that contains controversy

That the credit derivatives market has got this far without a major public dispute erupting between dealers and users is largely because of the efforts of ISDA, the International Swaps&Derivatives Association. In the eyes of many market professionals, the defining moment for the market came in 1999 with the arrival of ISDA's Credit Derivatives Definitions, which created the framework for standardized documentation.

No-one pretends that the documentation for credit derivatives is perfect or indeed completely standard. It has, however, provided clarity in place of opacity, has drawn together a fragmented market and has injected liquidity where it was sorely lacking before.

Before the arrival of the Definitions, default swaps - which are essentially insurance contracts - were drawn up using lengthy legal documents. "You needed to do serious proof reading to see what was covered and what was not," says one dealer. "That put a lot of people off. But now the bottom line is that it is very clear what you are supposed to do and when."

Although the ISDA documents have provided much needed clarity, some observers say there is still a long way to go. "The documents have done what they were supposed to do, but they caused uncertainty and ambiguity," says a banking regulator. "Wherever there's ambiguity, people will contest things. And credit derivatives will always have the problem that credit events are difficult to pin down."

Andrew Tinney, global head of investment banking at Andersen, says: "The traditional default swap had a reference asset against which you could judge a default. Now there is a much broader definition of default, and it is much more difficult to pin down whether a credit event has occurred."

This raises doubts about whether the current documentation is sufficiently robust to withstand the wave of credit events, and consequent disputes between market participants, that might result from the current downturn.

So far the documentation, and ISDA, have passed the tests that have been thrown at them. Most problematic was the restructuring of US insurance company Conseco's bank debt in October 2000, which ignited a major row between protection buyers and sellers as to whether the restructuring had constituted a credit event.

The depth of feeling on all sides provided the impetus for the formation early this year of ISDA's credit derivatives markets practices committee, under the chairmanship in the US of JPMorgan's Blythe Masters and in Europe of Lehman Brothers' Paul Varotsis.

This committee, commonly known in the market as the G6, draws together a six-strong group of dealers, bank hedgers and protection sellers - three in the US and three in Europe. In the US, the representatives are from Morgan Stanley, Bank of America and Ambac Assurance; in Europe they represent BNP Paribas, National Australia Bank and Ace Guaranty Re.

"Dealers in the market had already been quite vocal in getting their views across on restructuring, and we wanted to make sure that the other users of the market [the bank portfolio managers and the protection sellers] had a voice in this and other credit derivatives issues," says Louise Marshall, policy director at ISDA in New York.

The first priority for the new G6 was a resolution of the restructuring issue, which was settled early in May. Since then, however, there has been a division in the market between the US, where most trades are carried out using ISDA's "modified restructuring" language, and Europe, where they do not.

Just as potentially damaging as the Conseco affair was Railtrack's financial collapse in October this year, which raised the issue of whether convertible bonds should be deliverable. ISDA, which had been working on the issue of convertibles, zero-coupon bonds and contingent claims before Railtrack was put into administration, clarified the issue speedily by saying that they were.

In the Railtrack incident, the dealing community reportedly stumped up funds to resolve what could have become a damaging dispute. Hedge funds had been using credit derivatives to hedge their debt exposure to Railtrack convertibles, with the protection sellers apparently unaware that the convertibles could be used as deliverables in the event of default. It is claimed that at least some intermediaries had been turning a blind eye to this knowledge gap.

"Because it's a new market you are constantly finding new issues, such as whether convertible bonds should be deliverable," says one dealer. "In the case of Railtrack, the market had not assumed that CBs were deliverable. But ISDA showed leadership in clarifying the issue."

Early in November ISDA published its supplement relating to "Convertible, Exchangeable or Accreting Obligations", completing the work that had been suspended during the Railtrack issue, and at the end of the month published its supplement on successor and credit events to the 1999 Definitions.

Dealers believe ISDA plays a key role in ensuring that disputes are resolved. "It is in everyone's interest that contracts get settled," says Guy America, head of corporate credit derivative trading at JPMorgan. "There are so many counterparties involved and some of them are not exactly the least litigious of people - such as insurance companies and hedge funds," he says. "So the overriding view from the market is that we have to get these things settled in a way that would stand up in court."

But other observers worry that a wave of disputes over credit events and documentation could bring the market to a standstill. "In the case of Railtrack, no-one in the back office knew what to do, so the traders had to sort it out," says one UK-based consultant.

"That meant that trading effectively stopped across the whole market for a while. That is not the sign of a mature market. Railtrack worked, but if you had four or five similar things happening at the same time, you would have a big problem - without a doubt."

ISDA executives see their role as that of "a facilitator". Executive director and CEO Bob Pickel sees similarities between the credit derivatives market today and the interest rate swaps market in the mid-1980s.

"There are some growing pains in terms of market practice and documentation, which are almost inevitably part of the growth and development of new markets," he says. "But overall we see with the credit derivative product a strong commitment to the market, and an understanding from all parties that this is a powerful tool for managing their credit risk."

Besides establishing and maintaining the integrity of the documentation, ISDA's other key role is working with the Basle committee on the question of bank capital requirements.

A major success was chalked up earlier this year when what had come to be called the W charge was dropped from the Basle 2 proposals. The committee had proposed the imposition of a 0.15% residual risk factor for credit derivatives.

On behalf of its members, ISDA argued that the W factor was unnecessary. Thanks to lobbying by some of the major bank users with members on the Basle committee, the charge was moved from pillar 1 (regulatory capital) to pillar 2 (supervision).

This means that it will not be imposed as a standard charge, but can be imposed on institutions according to the regulator's judgment of their individual risk exposure.

Now ISDA is going in to bat again on the subject of whether or not restructuring should be included in a credit derivative contract in order to obtain capital relief. The BIS says it should be; ISDA members, predominantly its US members, say it should not. The issue is still under discussion.

As for work in progress, the ISDA committee will shortly start work on a comprehensive review of the 1999 Definitions, a move that underlines a general feeling in the market that the current documentation - though a significant improvement on what was available before - needs further refinement. This should be completed by the end of next year.

In recent weeks, deal structurers have reported increased demand among users for contracts offering narrower definitions of a credit event. "We've seen credit events in Europe for the first time and we'll see more," says Forbes Elworthy, co-head of structured credit at Dresdner Kleinwort Wasserstein.

"Reinsurance and insurance companies want to narrow the definition of a credit event. From a structuring and pricing point of view, we are seeing a larger audience for deals with more restrictive default definitions. But the wider market doesn't want to hear that because it doesn't want a market that has only recently become unfragmented to become fragmented all over again."

Jonathan Davies, head of global credit derivatives at PricewaterhouseCoopers, believes that the current credit meltdown could trigger a flood of disputes. "The fundamental problem is that you have protection sellers who don't want any credit events, you have protection buyers who want credit events, and dealers who want credit events but only to the extent that it provides a trading opportunity," he says.

A pressing item on ISDA's agenda right now, however, is Argentina. The association is setting up an emerging-markets credit derivatives committee, whose first priority will be to deal with the Argentina situation.

It is not at all clear whether Argentina's proposed voluntary restructuring constitutes a credit event. Even the three ratings agencies cannot agree whether Argentina is effectively in default or not.

But it is a pressing concern given the volume of contracts outstanding - some of them from several years ago, using old-style language - on the largest emerging-market debt issuer, and the potential for confusion as to which contracts are or are not triggered.

"Argentina is on the edge, but they've been smart at avoiding a trigger on the credit default swap contracts," says a London-based dealer. "They are breaking new ground, taking incredible care to avoid causing panic in the credit default swap market, and it looks as if they may get away with it."

The head of credit derivatives at another European bank says: "They [Argentina] are working like hell to avoid a default, but some people could start saying that a trigger event has already occurred. People are going out and taking legal opinions, and dealers are talking to each other."

He adds: "Like everyone, we are involved on every side. When so many people are involved, and when you have got to take delivery and make delivery, you have to create a consensus."

So far consensus has worked in the credit derivatives market, and dealers are making a great play of the fact. "This market is working and we want to shout about that," says a dealer at a US firm.

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