Dire predictions

Read the mainstream financial press, and you'd think the credit derivatives market is a ticking time bomb. Many of the articles on credit derivatives invariably make reference to Warren Buffett's long-ago comments likening derivatives to weapons of mass destruction. The inference is clear: we are slowly, inevitably, approaching the moment when everything will blow up, investors will lose their hard-earned cash, and shockwaves will cause the global financial system to crumble.

It's time, once again, to step back and look at the market with some semblance of objectivity. In essence, the credit derivatives market has allowed banks to reduce concentrations in their loan books by transferring those risks in tailored form to a broad range of investors, each with different investment horizons and risk appetites.

Certainly, this new 'originate-and-distribute' model, combined with strong appetite for loan assets among investors, has been criticised as being responsible for a loosening of underwriting standards among banks. That may be true for some institutions - but not all. This is perhaps an area chief risk officers and regulators need to regularly review.

Some observers have also noted that credit derivatives traders would, for the most part, not be able to cope with a flurry of defaults. There's no doubt this used to be a problem. However, huge progress has been made reducing the backlog in outstanding confirmations, while the International Swaps and Derivatives Association has been instrumental in developing standards for settlement. Banks can never rest on their laurels, but the progress has been encouraging.

Next, some observers point to the lack of transparency in the credit derivatives market. The fact that no-one knows who holds what, or what positions everyone is taking, means investors could all act in the same way when faced with a crisis - which could cause a liquidity crunch and have knock-on effects in other markets.

There is perhaps some merit in regulators having more information on positions to enable them to monitor liquidity and systemic risks. Dealers Risk spoke to do not, in theory, have a problem with this, so long as information is not disclosed publicly. Dealers and regulators could presumably work together to resolve this issue.

Credit derivatives have weathered every market disruption so far. That's not to say investors won't rack up headline-grabbing losses - but that's the nature of all financial markets. Any losses are likely to be far more manageable if they are divided among large numbers of investors, as opposed to being concentrated on the balance sheets of an ever-decreasing number of banks. There are still some teething problems, but the growth of the credit derivatives market has undoubtedly contributed to greater resilience of financial markets.

Nick Sawyer, Editor.