Quality regulation is key for credit derivatives development, say bankers

Effective regulation emerged as a key theme for the development of the credit derivatives industry, according to an industry discussion forum hosted by inter-dealer broker CreditTrade in London last night.

Speakers noted that participants and regulators needed to better understand and manage the risks associated with new products and the growing use of cross-sector risk transfer between insurance companies and banks.

“These are complex and bespoke deals,” said Clive Briault, head of prudential policy at UK regulator the Financial Services Authority (FSA). “Issues such as operational risk, pricing difficulties, lack of transparency and cross border-transactions all need to be considered, as well as inadequate senior management understanding and scrutiny of deals.”

The FSA, the UK's main financial watchdog, along with the Bank of England, have voiced public concern on a number of issues regarding credit derivatives, including whether risks are genuinely passed on to counterparties and the exposure of the insurance sector to the credit derivatives market.But Briault insisted the FSA was not "seeking to kill off the credit derivatives market". However, he added that the risks inherent in the business needed to be properly managed, and stated that, currently, in some cases they may not be.

“The CDS market needs to put more energy into regulation issues,” said Tim Frost, head of credit trading for Europe at JP Morgan Chase in London. JP Morgan Chase is the largest participant in the credit derivatives market and trades about 150 contracts on about 45 names during a busy London trading day. Speakers said transparency and visibility in pricing was also key to facilitating the effective growth of the market. “With the continuing evolution of contracts, we need an accurate approach to mark recovery rates and correlation risk,” said Frost. “The market's ability to calculate this needs to keep pace with the growth of the credit derivatives markets.”