Achieving efficiency gains

The dramatic increase in the use of the credit derivative market has created a watershed in credit risk management for investors and hedgers.

A credit derivative is a bilateral financial contract that isolates the credit risk of a reference credit and transfers that risk from one party to another. In doing so, credit derivatives separate the ownership and management of credit risk from other qualitative and quantitative aspects of ownership of financial assets. Credit derivatives, therefore, share a key feature of other successful derivative products: the potential to achieve efficiency gains through a process of market completion. Achieving market completion means credit derivatives enable the transfer of credit risk to the most efficient holder of that risk, even if the underlying asset containing the credit risk cannot be transferred to that holder. Until the advent of an efficient credit derivative market, credit remained a major component of business risk for which no tailored risk management products existed. Investors were constrained in their activities by the availability of publicly-traded assets in predetermined maturities and volumes. However, these are inefficient strategies because they do not separate credit risk from the asset associated with that risk. Consider a corporate bond which represents a bundle of risks, including duration, convexity, callability and credit risk (constituting both the risk of default and the risk of volatility in credit spreads). If the only way to adjust credit risk is to buy or sell that bond, which would affect positioning across the entire bundle of risks, there is a clear inefficiency. Fixed income derivatives introduced the ability to manage duration, convexity and callability independent of bond positions. Credit derivatives complete the process by providing the ability to manage default and credit spread risk independently. Credit default swap A credit default swap is a bilateral financial contract under which the protection buyer pays a periodic fee (typically expressed in basis points per annum on the notional amount) in return for a payment by the protection seller contingent on the occurrence of a credit event with respect to a reference entity. Credit-linked notes A credit-linked note is a security with principal and/or coupon payments linked to the occurrence of a credit event with respect to a specific reference entity. In effect, a credit-linked note embeds a credit default swap in a funded asset to create a synthetic investment that replicates the credit risk associated with a bond or loan of the reference entity. Credit-linked notes are typically issued on an unsecured basis by a financial institution but may also be issued by a collateralised special purpose vehicle (SPV). Credit-linked notes provide investors who cannot trade derivatives or do not have executed ISDA Master Agreements with access to the credit derivative market. Credit-linked notes may be issued directly by JPMorgan Chase Bank or through an SPV programme. Corsair is the brand name for JPMorgan’s proprietary SPV programme. Corsair vehicles exist in various jurisdictions to address investor needs as well as tax and structural considerations. Each Corsair vehicle has standardised documentation and low execution costs, creating a platform for efficient and timely credit-linked note issuance. Liquidity The credit derivatives market, particularly throughout 2001, has been the first to provide liquidity during times of overall market stress. A good demonstration of how the credit derivative market reacts in times of general market stress can be seen by examining trading flows before and after the week of September 11 2001. Based on the average of the four trading weeks preceding September 11, the weekly credit derivative trading volumes almost trebled when financial markets resumed full activity on September 17. During that period, the JPMorgan credit derivative desk intermediated consistent two-way flows. The percentage of protection bought versus protection sold did not change to a large degree. The credit derivative market is able to provide better liquidity during periods of market stress than the cash market because of the way in which the respective trading desks are traditionally positioned. Cash desks are typically long risk because they hold an inventory of bonds. Credit derivative desks are typically short risk because they hold an inventory of credit protection. During periods of market stress, clients can reduce long risk positions by either selling bonds or buying protection. At such times, cash desks are reluctant to increase their inventory and assume more risk by purchasing bonds from clients. In contrast, credit derivative desks are happy to go from short to flat by selling their inventory of protection (the equivalent of going long a cash bond). Credit derivative desks can also source additional protection from clients who had previously used the product to short credits and now wish to monetise that position. These characteristics allow the credit derivative market to maintain two-way flows and provide liquidity and accurate credit pricing when other markets are less active. The credit derivative market also provides liquidity to individual credits under stress. In addition to providing liquidity during times of overall market stress, time and again the credit derivative market remains open and liquid as specific credits experience stress and liquidity shortfalls in the cash market. The same factors which allow credit derivatives to add liquidity to a stressed market allow it to provide liquidity to individual names: an inventory of protection held by dealers and a desire among other clients to monetise naked short positions. The most recent and best example of how the credit derivative market provides liquidity to deteriorating credits is the decline of Enron. As disclosure of Enron’s off-balance sheet liabilities caused spreads to widen, credit default swaps in Enron became more active and continued to trade in standard size ($5m to $10m) across the curve. Eventually, Enron’s debt was downgraded to junk by ratings agency S&P, which caused Dynegy to pull out of a planned merger. When the downgrade occurred, liquidity in Enron bonds was limited to those maturing in August 2009 and trading was limited to amounts which rarely reached $5m. At the same time, dealer desks continued to sell their inventory of protection and helped clients to monetise protection they had previously purchased. Trading continued until Enron filed for bankruptcy protection in early December 2001. In addition to proving that the credit derivative market provides liquidity, the Enron bankruptcy proved the efficacy of credit derivatives as a product. Enron was the largest and most liquid entity in the credit derivative market to have a credit event. Once the bankruptcy occurred, credit default swaps were triggered and settled in an orderly and timely fashion without dispute – the product worked as expected. This is just the latest and largest example of the value added through credit derivatives. The use of credit derivatives has grown exponentially since the beginning of the decade. Transaction volumes have picked up from the occasional tens of millions of dollars to regular weekly volumes measured in hundreds of millions of dollars. While banks have been the foremost users of credit derivatives to date, it would be wrong to suggest that banks will be the only institutions to benefit from them. The end-user base is expanding rapidly to include a broad range of broker-dealers, institutional investors, money managers, hedge funds, insurers, reinsurers and corporates. Growth in participation and market volumes is likely to continue at its current rapid pace, based on the unequivocal contribution that credit derivatives are making to efficient risk management, rational credit pricing and, ultimately, systemic liquidity. By enhancing liquidity, credit derivatives achieve the financial equivalent of a free lunch, whereby both buyers and sellers of risk benefit from the associated efficiency gains. Credit derivatives can offer the buyer and seller of risk considerable advantages over traditional alternatives. Both as an asset class and as a risk management tool, credit derivatives represent an important innovation for global financial markets with the potential to revolutionise the way that credit risk is originated, distributed, measured and managed.

Demand for credit derivatives Until recently, the credit derivative market was perceived as a tool that banks used to achieve regulatory capital relief. Since 1997, there has been a dramatic increase in the use of credit derivatives by other active participants such as (re)insurers, asset managers, mutual funds, hedge funds, corporations and collateralised debt obligations, creating substantial growth and liquidity in the marketplace. The exponential growth of the credit derivative market has been a watershed development in credit risk management for both investors and hedgers across a broad spectrum of market participants and asset classes. Simply put, credit derivatives are fundamentally changing the way risk managers price, hedge, transact, originate, distribute and account for credit risk. They provide greater precision with which generic credit risk can be isolated, managed and transferred. Increased use JPMorgan estimates that the global credit derivative market had grown to $2000bn by year-end 2001, which is more than double the size of 2000, and has increased tenfold in the past four years. (Chart 3 illustrates the increase in use of credit derivatives over time by different sectors of the credit derivative market, driving growth.)

Extracted from JPMorgan’s “Credit Derivatives: A Primer”