Until last fall, many participants in the credit derivatives markets lived in mortal fear of what major regulatory agencies would say about credit derivatives. Would the Fed or the OCC declare credit derivatives hopelessly speculative? Would credit derivatives be ineligible for off-balance-sheet hedging treatment? These were critical issues to be resolved, since most dealers have aggressively marketed credit derivatives as a risk management tool appropriate for mid-sized commercial banks as well as their more sophisticated superregional brethren.

Although Generally Accepted Accounting Principles, which most banks use for regulatory reporting, do not provide guidance for the treatment of credit derivatives, the Fed, the OCC and the FDIC all issued letters last fall that outline their positions to date. Most of the comments are "Yes, but..." statements which offer suggestions, but clearly reserve judgment.

The United States' National Association of Insurance Commissioners, which develops model regulations for potential adoption by state insurance regulators, has also considered credit derivatives in its deliberations on investment-related standards.

Although market players have taken these letters as a step in the right direction, they note that the Bank for International Settlement (BIS) has remained noticeably silent on the topic. Currently, the BIS's suggested method for determining credit-based capital adequacy dates back to 1988. How to modify the calculation of this charge to accommodate a more sophisticated view of credit, which includes the benefits of diversification and more precise analyses of credit quality, is the subject of a hot behind-the-scenes debate.

Here's a summary of what the major regulators have to say about credit derivatives...for now:

The OCC
(www.occ.treas.gov)

The Office of the Comptroller of the Currency (OCC), which regulates U.S. domestic banks, released a document last August to review some of the regulatory issues associated with the use of credit derivatives for risk management purposes by end-user banks. The OCC Bulletin (OCC 96-43) recognizes credit derivatives as legitimate risk management tools: "Credit derivatives permit the transfer of credit exposure between parties-i.e., the buyer and seller of credit protection-in isolation from other forms of risk. These derivatives represent a natural extension of the market for similar products that unbundle risks, such as certain interest rate and foreign exchange products." This concept of credit derivatives as risk management tools applies to default swaps as well as to total return swaps. Like the Federal Reserve Board, the OCC is likely to equate credit derivatives with their underlying reference instruments. Also, the OCC emphasizes the need to consider counterparty credit risk in the case that a bank is buying credit protection from another institution.

The FDIC
(www.fdic.gov)

The FDIC, which regulates U.S.-based depository institutions and insures consumer deposits, came out with a brief letter on credit derivatives in August 1996. The FDIC's position appears, in principle, almost identical to the OCC's: credit derivatives are acceptable risk-diversifying tools, and, from a reporting perspective, should be considered analogous to their underlying reference credits. As with the OCC, the FDIC emphasizes that banks which use credit derivatives should fully understand the structures in question and have appropriate controls and risk management policies in place.

The Bank for International Settlements
(www.bis.org)

The Bank for International Settlements (BIS), a notoriously slow-moving entity, does not specifically recognize credit derivatives. Instead, banks holding credit derivatives used for risk management purposes are required to hold reserve capital for these transactions based on a set of criteria developed in 1988. These criteria include the (broad) credit rating of the obligor in a credit transaction, the type of exposure (drawn loans or potential contingent commitments) and whether the maturity of the transaction is more or less than one year. Because the BIS takes an additive approach to credit-based capital requirements, meaning that the risk associated with each individual transaction is added together, banks and other financial institutions that use credit derivatives in order to enhance their portfolio-wide diversification do not receive capital relief.

Currently, finding a way to reform the credit-risk-based capital requirement is of major concern both to BIS regulators and to credit market participants. Blythe Masters, one of the major architects of JP Morgan's CreditMetrics, explains that the Credit-Metrics methodology provides a less arbitrary alternative to the BIS approach, which considers the credit quality associated with both obligors and reference assets and considers how portfolio concentration can affect overall risk.

The Federal Reserve Board
(www.bog.frb.fed.us)

According to Joanna Frodin of the Federal Reserve Bank of Philadelphia, "Credit derivatives are following in the footsteps of other financial instruments that looked like financial toys at first but proved to be versatile tools of risk diversification, risk management and yield enhancement." She adds, however, that because so much of the credit derivatives market today is nonstandardized, regulators will be considering the regulatory and supervisory treatment of credit derivatives on a case-by-case basis. So far, the board of governors of the Federal Reserve has come out with one document, Supervisory Letter SR96-17, as an interim set of guidelines (the document was released in August 1996).

In broad terms, the Federal Reserve is considering most credit derivatives as being analogous to letters of credit and other off-balance-sheet guarantees. That's because the bank providing credit protection through a credit derivative can become exposed to the reference asset in a credit derivative just as it would if the reference asset were on its own balance sheet.

Consider, for example, a typical credit swap in which Bank A is contractually obligated to make a lump-sum payment to Bank B in the event of a credit event at Company C. Through the credit derivative, Bank A takes on considerable exposure to Company C. In these cases, the Federal Reserve requires dealers providing this sort of credit protection to hold capital reserves against credit risk associated with the reference asset.

However, in the case of a total return swap, which may include provisions for the depreciation or appreciation of the reference asset, the bank providing risk protection can deduct any amount paid to its counterparty from the notional amount of exposure to the reference asset when calculating its capital charge.

For end-users of credit derivatives, the question becomes whether or not your credit derivative provides sufficient protection to be considered a guarantee for regulatory capital purposes. Typically, guaranteed assets are associated with reduced capital requirements. However, whether or not a credit derivative truly qualifies as a guarantee depends on whether the maturity of the credit derivative matches the maturity of the asset it is protecting; how default or other credit events are described in the transaction's documentation; and the size of the payout in the event of a default or other credit event.

In addition to exposures to reference assets, the Fed's supervisory letter, as with the OCC letter, also considers good old-fashioned counterparty risk. If you purchase a credit derivative to, say, receive a guaranteed payment in the event of a credit event, you may have mitigated your exposure to the reference asset, but you have gained exposure to your counterparty.

For purposes of calculating standard capital requirements, credit derivatives are, for now, to be treated as off-balance-sheet direct credit substitutes. This means that, for institutions on the sell side of a credit derivative, 100 percent of the notional amount of credit derivative must be included in calculations of risk-based capital requirements. On the buy side, this means that the notional amount of the transaction is assigned a risk weight according to the credit quality of the guarantor. For example, if the guarantor is an OECD bank, then the percentage of the notional amount will drop to 20 percent. This buy-side risk-weighting approach to calculating capital requirements for credit derivatives also applies to sell side institutions that have written a credit derivative and, in turn, hedged their exposure through another credit derivative.

However, banks that choose to use the optional, market-risk-based capital requirements that the Fed now allows may be able to reduce capital charges if a considerable portion of their credit exposures are guaranteed by high quality non-OECD institutions. In this case, banks would mark their net exposures to market and take the additional capital charges for counterparty-specific exposures. According to Bankers Trust's Phil Borg, calculating market-based capital requirements could provide limited relief from capital charges to financial institutions with sizable credit portfolios. He cautions, however, that this method is only appropriate for institutions that have extremely sophisticated risk analytics and systems in place that allow them to calculate portfolio-wide market risk within a Value-at-Risk or similar portfolio-wide framework.

The National Association of Insurance Commissioners
(www.naic.org)

Insurance regulation in the United States is conducted on a piecemeal basis; each state designs its own rules and regulations. The National Association of Insurance Commissioners (NAIC) was formed in order to foster consistency among state insurance regulations. Basically, the NAIC designs model regulations and then distributes them to state insurance commissions, which can choose how and to what extent they should be implemented locally. According to Larry Gorsky, chairman of the NAIC's investment committee, the organization released a document last year that generally discussed the use of derivatives-including credit derivatives-for hedging and limited yield-enhancement purposes. Gorsky explains that the investment committee is now looking closely at how derivatives can be used to replicate various cash instruments. Credit derivatives, for example, could be used to replicate certain bonds, loans or high-yield instruments. From a reporting perspective, the NAIC is leaning toward considering credit derivatives used for replication as equivalent to the derivative's underlying reference asset. "We will be doing a lot of work on credit derivatives over the coming months," notes Gorsky.

The Bank of England
(www.bankofengland.co.uk)

Recently, the Bank of England released a draft document explaining its position on credit derivatives and calculating associated capital requirements. Unlike the Fed or the OCC, the bank recognizes distinctions between credit derivatives that function mostly as "guarantees" and credit derivatives that act as "trading assets." In practice, this means that credit swaps-which most closely resemble letters of credit and other traditional guarantees-receive more lenient treatment than total return swaps, despite the fact that users may purchase both types of instruments for risk management purposes. Most dealers who have commented on this draft call this distinction "artificial" and unwarranted.