After the hype comes the hard work of building a new market from the ground up.

By Karen Spinner

Credit derivatives dealers have a lot in common with U.S. manufacturers in China-perhaps a little too much in common. Both groups have hopes for the development of an enormous market that, with the right product and marketing strategy, could generate undreamed-of profits. Both have had unanticipated logistical, regulatory and strategic difficulties. Both have only modest returns to show for their expenditures of time and capital. And though they haven't figured out how to make a lot of money, both have no plans to abandon their efforts.

That in a nutshell is the credit derivatives market today. Globally tight credit spreads are hurting the market. Senior managers are more skeptical about the accelerating salaries being paid, and nagging problems with documentation regulation and pricing remain. But volume and liquidity are growing at a healthy pace.

The initial, giddy optimism about the product is clearly giving way to a more sober assessment of the work that must be done to create truly liquid-and profitable-credit markets. "Now that all the hype is dying down, there's a lot of pressure on trading firms to produce results," says David Crammond, president of Intercapital USA, a New York-based brokerage. "If 1997 doesn't produce meaningful trading profits, institutions will have to ask themselves: How many more resources should we commit to this business?"

Recent turmoil in a number of credit derivatives desks may indicate a certain amount of management skepticism in the markets' long-term potential as a highly liquid profit center. Citibank, for example, reportedly ejected nearly its entire credit derivatives staff because-according to various rumors-they were not generating profits in line with their compensation. "Management is breathing down our necks to write tickets," says one New York-based credit derivatives trader. "Credit derivatives cannot be a cost center any longer."

Although the credit derivatives market hasn't caught fire in the last few months, there's evidence of slow, solid growth. "It is getting busier now," says Intercapital's Crammond, who estimates his firm does anywhere from 30 to 70 serious inquiries a week. "We can count on three out of five days being extremely hectic-and that's a great development. Intercapital has hired six full-time credit derivatives specialists over the past year to build a credit desk from scratch. They are now in the process of computerizing all the inquiries it receives to help us identify market trends."

There's also evidence of an increasingly balanced two-way market for credit exposure-supported by investors who want to buy credit risk and hedgers who want to lay it off. "We are seeing more speculative positions which, to a certain extent, are coming from traders who are experiencing management pressure to generate profits. And, as more people begin to understand credit derivatives, we are also seeing more hedging in the credit markets," says one New York-based broker. He notes that much of the hedging transactions are coming from large corporate lenders who are attempting to hedge the concentration risk associated with their loan portfolios.

And dealers are rushing to jump on the credit derivatives bandwagon. Paul Colello, who heads up Credit Suisse Financial Products' derivatives desk in New York, estimates that there are now 15 dealers willing to quote prices in basic products. Recent entrants include Merrill Lynch, Lehman Brothers, Citibank and Bank of Montreal, while "old hands" in the credit derivatives arena include JP Morgan, Bankers Trust, CSFP, Chase Manhattan, Bear Stearns and CIBC Wood Gundy.

Strategically speaking, most dealers are trying to remain generalists in the credit derivatives market because, so far, no one knows which particular structure will be the next to "take off." Right now, the "meat and potatoes" of credit derivatives include default swaps, total return swaps and credit-linked notes. (See box above.) More exotic structures may pay out based on the behavior of a basket of reference credits, change character over time or include multiple contingencies. As with any species of derivative, the only limitation to potential credit structures is the imagination of financial engineers. And typically, most of these exotic structures are custom-tailored to the specific needs of individual clients.

Although some dealers are widely recognized to have particular strengths-for example, JP Morgan is known for default swaps and credit-linked notes while Bankers Trust is known for its work in total return swaps-most will characterize themselves as Renaissance players. "CIBC Wood Gundy has consciously adopted a generalist strategy. We want to be active participants in the credit markets as a whole, not specialists in a single type of structure," says Shaun Rai, acting head of credit derivatives at CIBC Wood Gundy. Similarly, the larger dealers are working hard to develop and maintain a presence in the global credit markets. Bankers Trust, which has one of the most experienced credit derivatives groups on the Street, has just recently expanded its credit derivatives operations to include representatives in London and Tokyo in an effort to enhance servicing for Asian and European accounts. According to one New York-based headhunter, "Dealers and brokers are still staffing up their credit derivatives desks. Two of my biggest projects involve dealers putting together credit trading offices in East Asia."

Spread problem

Ironically, the growing interest in credit derivatives markets comes as credit spreads approach all-time lows. Credit markets, however, are fast becoming an appealing alternative to the increasingly commoditized currency and interest rate markets. "Spreads are tight in the credit markets, but they are even tighter in, say, interest rates or currencies," says Blythe Masters, who heads up JP Morgan's credit derivatives business.

Masters explains that the tight spreads are a result of a relatively buoyant global economy and a global credit market that has suffered relatively few major credit events. The market is pricing this perceived low level of credit risk into the premium investors receive for holding credit risk. Still, these historically tight credit spreads are at a relative premium to current spreads associated with market risk, and Masters notes that leveraged credit investments are becoming increasingly popular with hedge funds and other proprietary investors with an appetite for big bets.

To appeal to investors in the current tight-spread environment, dealers have concentrated much of their R&D on yield-enhancing products and strategies. "We are seeing increased interest in yield-enhancing products that can, say, provide the return of a non-investment grade product at a lower level of risk," says Gregg Whittaker, global head of credit derivatives at Chase Securities. The movement toward synthetic structures-perhaps kicked off by JP Morgan's $594 million note linked to the credit of Wal-Mart stores last August and Chase's subsequent issuance of securities based on a portfolio of noninvestment-grade loans called the Chase Secured Loan Note Trust (see Derivatives Strategy, December-January, page 20)-has continued as spreads remain lackluster.

The tight spreads have also increased investor interest in straight arbitrage deals. Basically, this entails taking advantage of the differences in how credit is priced within a company's capital structure. For example, if you think that Company A's credit is worth more in the bond market than it is in the corporate loan market, then you can use credit derivatives to maintain a long position in "bond" credit and a short position in "loan" credit. CIBC's Rai says that his firm has developed proprietary models in order to identify irrational differences in credit pricing.

Tad Lundborg, serior vice president in credit derivatives at Tullet & Tokyo Forex in New York, notes that, in the future, credit spread options may gain in popularity because they can give end-users protection in the event of substantial unfavorable credit migrations short of default. "If, for example, a reference credit moves from single A to double B, spreads will move to reflect this change," he says. "End-users who have purchased spread options will be able cash in-even though the reference credit hasn't actually defaulted."

New arguments for using credit derivatives are appearing monthly. Large dealers are also looking at how credit derivatives can benefit their internal operations. According to Phillip Borg, head of global credit derivatives at Bankers Trust, dealers can exploit a number of synergies between credit derivatives and the cash markets. "Although asset swaps, for example, can be hedged using default swaps, this is only going to happen when there is good communication between the credit derivatives and asset swap groups, or when they are part of the same business line," he says. "These synergies exist throughout the debt industry. That's why credit derivatives at BT is in the same business line as the underlying cash businesses." Other dealers have positioned credit derivatives groups in the same fashion.

Credit derivatives have been pitched as an effective way to get around the increasing correlation within the debt and equity markets. "Both U.S. equities and bonds have become increasingly correlated with each other over time," says Mac McQuown, a vice president at San Francisco-based KMV, a credit pricing research and development and software firm. "This means that where 20 or 30 years ago you could reap diversification benefits by holding 50 different equities, today you would require 3,000. A portfolio of U.S. corporate debt, which is even more highly correlated than U.S. equities, might require 30,000 names to achieve a reasonable level of diversification." The solution: using credit derivatives to access an increasingly diverse menu of global exposures to maintain traditional levels of diversification.

Credit derivatives are also being pitched as a new way to generate returns in a post-European Economic and Monetary Union environment. The argument is that EMU will greatly reduce the opportunities for taking on intra-European market risk by providing a common currency and borrowing rate for much of Europe. Now, for example, French and German government bonds are priced differently because of the markets' different perceptions of the two countries' respective interest rates and currencies. But in the post-EMU landscape, any pricing difference between those two bonds would be entirely a result of the relative perception of the two countries' credit risk.

Finally, credit derivatives are continuing to win converts en masse among investors in emerging markets. "In the emerging markets, the next stage of development will include credit derivatives based on domestic instruments," says Oka Usi, global head of credit and emerging markets derivatives at BZW. "For example, credit derivatives might allow an investor to gain exposure to a peso-denominated bond issued by a Mexican company while laying off the associated currency or local interest rate risk."

Nagging problems

Liquidity, however, remains a serious problem for most participants. "It is very difficult to do a credit deal of large size," says one portfolio manager for a large global bank. "Typically, the biggest deal you can do is around $25 million to $50 million. I believe that we need to see a more robust interdealer market for credit derivatives to take off."

Currently, there are few accurate estimates of the current size of credit markets. A survey by the British Bankers Association last year estimated the London market for credit derivatives to be somewhere between $20 billion and $30 billion. An anecdotal survey conducted by CIBC, also in 1996, estimated the global credit derivatives market at somewhere around $40 billion. Other sources-all of them dealers-suggest the market in 1997 could grow as large as $100 billion. Other end-users have expressed similar fears about the depth of the market. "We would consider using total return swaps to change the credit profile of some of our held-to-maturity investments, but we are concerned about being able to unwind these transactions," adds an insurance executive at a New Jersey-based insurance company.

Although some of the liquidity deficit comes from the nature of credit itself (that is, every corporate or sovereign credit is unique and therefore not perfectly interchangeable), much of it results from shortfalls in market infrastructure that can be easily corrected. According to BZW's Usi, "The concern over liquidity in the credit derivatives market may be overblown. Consider how long it took for the nascent swap markets to build momentum. At this point in their evolution, the credit markets today are about where they should be."

One of the most critical hurdles to higher liquidity is perhaps one of the most mundane. Lawyerly wrangling routinely delays transactions because the International Swaps and Derivatives Association has yet to finalize documentation for basic credit derivatives structures or even for standard definitions of credit events such as defaults. For example, in a default swap conducted between two banks and intermediated by a broker, legal departments from both banks must develop and approve documentation. According to one broker, "Sometimes this can take as long as five days, a considerable impediment to liquidity."

All this gives interdealer brokers an increasingly important role to play, according to Garry Philip Rayner, director of credit and structured derivatives at Prebon Yamane. The broker's role in a credit derivatives transaction goes far beyond simply matching two sides of a deal; often it will include providing negotiation between two counterparties as they attempt to hash out the terms, choices and conditions of a deal. These terms and conditons can often create vehement disagreements between counterparties because of the idiosyncratic nature of many credit derivatives and the current deficit of standard documentation and terminology.

Even in the case of a relatively straightforward default swap, there is a multiplicity of issues to be negotiated. These issues may include the definition of "contingent credit event"-what will happen in the event that a reference debt asset is taken off the market during the life of the swap, how settlement will occur and so on. "Standard ISDA documentation, which is on the way, will help to make this process less arduous," says Rayner. "And once two counterparties come to an agreement on one deal, future negotiations can be considerably more streamlined." He emphasizes that the best brokers try to ensure that both counterparties have the internal and legal resources to resolve negotiations in a timely fashion, so that delays and subsequent market movements will not affect the economic rationale for the transaction.

But help is on the way. ISDA is currently in the final comment period for a standard credit swap confirmation; this document includes a menu of transaction attributes that theoretically will allow users to describe idiosyncratic deals with generic documentation. ISDA's documentation committee is also at work on a set of generic terminologies, including a definition of default.

"Because credit is rather idiosyncratic, it may be impossible, even with standard documents, to completely eliminate the negotiation component of conducting a credit transaction," says Morgan's Masters. "However, the ISDA documents are very flexible, and they will allow counterparties to select from a menu of defined choices rather than starting from ground zero." Masters adds that as financial institutions do more credit deals, they will get better at rapidly processing the related documentation in a timely fashion. "I think firms have gotten much better at processing documents, and I doubt that it is a serious impediment to liquidity."

Regulatory uncertainties that have hurt liquidity are also on their way to resolution. "We have seen a lot more interest from regional banks since the Federal Reserve and Office the Comptroller of the Currency (OCC) came out with more clear guidance on their treatment of credit products this September," says Chase's Whittaker.

Some gray areas remain, however. Many insurance companies, which in theory could use credit structures to mitigate their risk associated with investments they are required by law to hold to maturity, are holding off on entering the credit markets until insurance-specific regulations address credit derivatives. Likewise, Masters explains that the Bank of International Settlements has yet to provide a clear statement on how credit derivatives might mitigate European banks' credit-related capital charges.

In an effort to preempt the regulators and create an industry-wide standard for the measurement of credit risk, JP Morgan has released CreditMetrics (See Derivatives Strategy, May, p. 6), which takes a Value-at-Risk approach to determining portfolio-wide risk associated with credit. In an unusual show of cooperation, JP Morgan has recruited other dealers-including BZW, Deutsche Morgan Grenfell, Swiss Bank Corp., the Union Bank of Switzerland and the Bank of Montreal-to help distribute CreditMetrics. The common goal is to set an industry-wide benchmark for credit risk and thus raise market participants' comfort level with credit structures.

The development of sophisticated, quantitative credit risk management at an increasing number of banks is another prerequisite for continued growth in the credit derivatives markets. This makes intuitive sense. After all, financial institutions need to be able to pinpoint their credit risks in order to be able to take advantage of hedging opportunities in the credit derivatives markets.

Price fight

Another deficit in today's credit markets is the lack of an industry-standard pricing model for credit. "Most traders today do not use a model to price credit derivatives," says ICAP's Crammond. "Instead, they look at the price of the underlying asset to provide an estimate." Some dealers argue that this "guestimation" method does, in fact, provide a useful indication of where credit derivatives may be priced. "One of the challenges for dealers will be to effectively price credit derivatives based on debt instruments for which there is little available public information," notes BZW's Usi. But the extent to which pricing models are a "must have" for participation in the credit derivatives market is the subject for a considerable debate, often fogged by self interest.

"I think people can get too hung up on the model issue," says CIBC's Rai. "Evaluating credit is not a new task for banks. They have been making millions of dollars on corporate loans for decades." According to Morgan's Masters, "Every institution has its own approach to valuing credit, based on its years of experience as well as the composition of its portfolio. The value of any credit instrument is relative. For example, a bond issued by Company A-even if it has a AAA rating-may not be worth much to a company that already offers Company A a substantial line of credit."

Masters adds that for basic credit structures such as vanilla credit swaps and total return swaps where the reference credit is a loan or a bond, models are generally not necessary. "Bond traders don't use models to trade," she says. However, she emphasizes that for market participants using credit products where the reference credit may be a basket of credits or where there is optionality-as in the case of credit spread options-modeling is a useful tool.

"Of course dealers say that you don't need a pricing model; they love to trade with counterparties that don't use models," says Don Van Deventer, president and founder of Kamakura, a software and financial research and development firm that has plans to offer a credit-pricing module in the near future. "But theoretical prices are an important supplement to market prices."

Van Deventer adds, however, that efforts to develop a standard pricing model for credit have been stymied by a lack of historical data. There are three main reasons for this: credit derivatives themselves haven't been around that long; there is a dearth of data on the underlying assets upon which credit derivatives are typically based (that is, corporate bonds and loans); and credit is idiosyncratic, meaning that all credits which fall into the same broad ratings category are not interchangeable.

Another stumbling block on the path to more liquid credit derivatives is the lack of appropriate systems and controls that can accommodate next-generation credit products. Although CreditMetrics promises to go along way toward providing a standardized methodology for credit risk measurement, most institutions have yet to implement credit Value-at-Risk-or other quantitative credit risk management methodologies. Likewise, most risk management systems on the market cannot handle credit derivatives. According to one New York-based broker, "I've seen a lot of traders input credit derivatives into market risk management systems by recording the tickets as corporate bonds."

While this is better than storing credit derivatives in your desk drawer, it is not ideal. If the underlying asset associated with your credit derivative is, in fact, a corporate bond, then your risk analyses may suffer from inaccuracies because of basis risk, or the difference in how the bond and its corresponding credit instrument are priced. If your reference credit is something other than a corporate bond, then you basically have oranges residing in a system designed to make apple pie.

Ironically, the credit derivatives market is building itself up into one of the most quiescent credit markets in recent memory. The current low premiums for credit risk, in fact, seem to be keeping a lid on growth in credit products. "Because we haven't seen any big credit events, potential hedgers are not necessarily putting credit risk management at the top of their list," says one New York-based broker, "and, because spreads are historically low, some investors may be holding out for more volatility."

While they watch their market bulk up, some dealers quietly admit they are waiting for another twist in the credit cycle-a time when credit spreads were on the upswing and a big credit disaster or two caused investors to pay more attention to the credit risks in their portfolios.

If history is any indication, the golden age of credit derivatives may be just around the corner.

Some Common Credit Derivatives... Credit default swaps: Credit default swaps are analogous to letters of credit. On the "fixed" leg of the swap, the counterparty who is buying credit protection agrees to pay a periodic fixed payment over the life of the swap. In return, the counterparty who is selling credit protection agrees to make a conditional payment should the agreed-upon "reference credit" default or experience some other mutually agreed-upon credit event. This is the "floating" leg of the swap. The reference credit is typically a corporation or some other entity to which the buyer of credit protection has some sort of exposure. Total return swaps: A total rate of return swap transfers the total economic performance of a reference asset or index-including cash flows and capital appreciation or depreciation-from one party to another. The total return payer pays the total rate of return on the reference asset plus any appreciation; the total return receiver pays a floating rate plus any depreciation on the reference asset. This structure allows one counterparty to hedge the risk of an asset while it remains on the books. Total return swaps are also flexible, allowing users to buy protection for, say, the last two years of a five-year bond. Total return swaps are particularly popular among insurance companies which, for regulatory purposes, are required to hold some instruments to maturity. Credit-linked notes: A credit-linked note is an on-balance-sheet, cash market structured note, typically issued by a special purpose trust vehicle. The note represents a synthetic corporate bond or loan, because another credit derivative (such as a credit default swap or a total return swap) is embedded within the structure. The performance of credit-linked notes may be associated with a single reference credit-or a basket of reference credits. Credit spread options: Credit spread options are simply options on a particular reference credit's credit spread in the loan or bond market. One party pays a premium up front in return for a lump sum payment in the event that the reference credit's spread crosses a certain threshold.