FSA warns of default risk

The growing use of credit derivatives and the rise of private equity mean that a large-scale default could be a much more complex and serious event in the future, according to the UK Financial Services Authority.

In a discussion paper released yesterday, the FSA said increased use of credit derivatives to repackage and reassign debt could "make it difficult to identify who ultimately owns the economic risk associated with a leveraged buyout and how these owners will react in a crisis".

The paper added: "These factors may create confusion which could damage the timeliness and effectiveness of workouts following credit events and could, in an extreme scenario, undermine an otherwise viable restructuring."

The UK financial watchdog plans to investigate firms' plans for dealing with defaults "as a matter of priority". The investigation would be "a key area of our focus during the next 18 months", the FSA added. This is a particular risk, as levels of leverage and the recent decline in the economic cycle makes a default - or several defaults - inevitable in the private equity sector, according to the authority.

Private equity involvement also increases the risk of market abuse, in particular through the credit default swaps market, and would create a smaller, less transparent equity market, the FSA warned.

Market participants have been invited to comment over the next five months.