What role can credit derivatives play in developing markets?
Vinod Kothari: Depending upon how you use them, credit derivatives may either be hedging tools (to protect against credit risks inherent in exposures held by banks), or trading tools (as a proxy tool to allow trading in the general credit of a reference entity, and thereby replicating a cash bond). In practice, credit derivatives trades today are more trading tools than hedging tools.
There is no data to confirm this, but that is a view generally shared by credit derivatives dealers. However, at the end of a chain of trades, there might be somebody using it for hedging as well.
Head of the US Federal Reserve Bank Alan Greenspan and others have lauded credit derivatives for their hedging potential. However, the hedging use is relevant only for someone who actually has an exposure in a reference entity. But when a US-based dealer buys or sells protection referenced to Chinese names, he may not have an actual exposure to hedge.
But the trading intent is at least as much, if not more, significant as the hedging motive. The credit default swap (CDS) trade is an easy and global market that replicates the cash bond market. A cash bond arises only when the reference entity actually issues the same.
CDS trades may take place without any actual funding. The synthetic market is not affected by any of the inflexibilities and limitations of the cash market - lack of availability, regulatory restrictions, etc.
Being an efficient tool of pricing the risk of credit default by the reference entity, the CDS market provides the most objective tool for pricing of credit risk. Take, for instance, Peoples Bank of China as a traded name in the CDS market. As the market is global, free of frictions, it allows the pricing of unsecured credit of Peoples Bank of China to be most transparent, eventually leading to more efficient and arguably cheaper access to credit.
The CDS market may not immediately lead to funds flowing into the corporates in question, but then, by allowing the traders an alternative and unfunded platform to trade in Asian credits, it is symbolic of the interest international investors have in the reference credits. The interest in the CDS market may well be converted into actual cash, and lead to development.
Do you have any statistics for the growth of this market in either China or India?
I don't think there would be much of domestic market for credit derivatives in either China or India. In India, for instance, there are draft rules for credit derivatives that have been lying unpromulgated for almost a year now. I don't think the Chinese regulators have issued any regulations governing CDS trades.
But the CDS trade is not a domestic market. Most trades know of no geographical limitations. A protection buyer may be a Singaporean bank, the protection seller may be a hedge fund in London and the reference entity may be a Chinese company. So it doesn't matter whether trades are taking place inter se between domestic players.
Looking at the expanding range of players in the market, its only a matter of time before domestic trades pick up. In fact, there might be interesting arbitrages between the domestic and international markets.
What is the special relevance of credit derivatives to lesser developed financial markets?
We have talked of the relevance of credit derivatives in developing a transparent credit risk pricing mechanism. There is yet another significant use I'd like to stress. That is the synthetic securitisation, whereby funding of SMEs may be supported by credit derivatives. Germany's KfW has very successfully done it primarily in Germany and lately in Austria as well. This is an area where Asian banks can operate.
The structure operates as such.: banks that originate loans to SMEs sell the credit risk in their loans (without selling the loans) to an intermediary, such as KfW. The intermediary pools the credit risk of various originating banks, and packages the same into credit linked notes and sells them to the capital market.
Investors have therefore purchased the risk of the SME loans. And the originating banks, now free of such risk, will happily originate more loans, leading to easier access to SME credit. I believe Singapore's SPRING is working on a similar model, but it might be a cash securitisation model rather than synthetic. Synthetic structure would be far easier than cash structure when it comes to securitisation of SME credits.
What level of maturity does such a market need? What key legislative or regulatory benchmarks can progress by measured by?
The credit derivatives market is a very fast growing market and nothing that moves very fast can escape the attention of the regulators. While there are regulatory concerns, the market remains largely unregulated. There are reporting requirements in different markets whereby regulators collect data about credit default swaps, but it is still largely unregulated.
However, banks' capital norms need to be spelt out in relation to credit derivatives trades. That is a minimal requirement for credit derivatives trades to come up. The rules are clear from the recent Basle II statement - central banks do not have to invent the rules. But they need to implement them. Neither India nor China have done that so far.
What role could CDs play in an economy such as China's with a closed capital system and a crumbling banking system?
That the country has a closed capital system does not affect credit derivatives trades. The global deals can continue to happen without being affected by the local regulations. And domestic deals can always happen between local players. The significance discussed above is not frustrated by the capital controls.
The second issue is about the health of the banking system. This is both a challenge and an opportunity for the credit derivatives market. It is well known that the collapse of Argentina, Enron or Parmalat did not affect banks internationally as substantially as they should have - since the risks had been spread out using credit derivatives. Credit derivatives provide an efficient mechanism to diffuse risks into the capital markets. Thereby the health of the banking system improves. In addition, banks may also use credit derivatives to improve their regulatory capital position.
Would you expect banks from developing economies like China to buy the protection from foreign counterparties? Would the fees charged be outrageous? How would prices be discovered?
The price discovery for credit derivatives is more closely related to the credit of the reference party - the obligor. The credit of the protection seller is important, but not the credit of the protection buyer. The protection buyer is comparable to an insured, and has money to receive in the event of a default. So, the fact that the protection buyer is from an LDC country does not have impact on the prices.
What type of CDs would you expect to see?
The market today is mostly a credit default swap market - this is true for the global market. For the Asian market, it is almost entirely a credit default swap market. Credit default swaps are quite handy as proxies for the general credit of the reference party. Of late, another variant of credit default swaps has come up - equity default swaps. Here, the swap is referenced to a substantial and permanent fall in equity prices of the reference party. This is arguably more transparent trigger mechanism than credit default swaps which are based on traditional, often not public, measures of credit default such as failure to pay and bankruptcy.
I would expect both single name and portfolio default swaps to develop in the region. Portfolio default swaps are particularly important from the viewpoint of a bank transferring the risks of a portfolio - such as the SME loans portfolio discussed above.
What are the risks of CDs with an inexperienced player, such as a Chinese bank?
Inexperience may be painful anywhere, particularly for a high leverage activity such as derivatives - you are acquiring risks but you may not be investing capital at all. The fact that you are inputting capital in a business is a great restraint itself, but getting into a derivatives trades is like betting or bidding - you might be bidding far more than you have.
Capital regulations, which require banks to hold capital equal to the first loss portion of tranched credit derivatives, is an important protection against the temptation to bid too much on credit derivatives. Both India and China need to put these regulations into place soonest.
The simple lesson for an inexperienced player is: do it, because that is how you gain experience. But then, don't try to run, before you learn to walk properly!
Vinod Kothari runs an extensive credit derivatives website at www.vinodkothari.com
