Credit derivatives, which are touted as tools to help banks manage the risks in their loan portfolios, have been slow to catch on with their intended customers.
But dealers are mounting an effort to convince end-users that these complex products could ultimately help them avoid the kinds of loan problems that hurt the industry during the 1980s.
In their current form, credit derivatives give lenders the ability to reduce specific credit exposures through a series of transactions involving traditional products like options, forward agreements, and swaps. The value of the transactions are determined by reference securities, such as corporate bonds, corporate loans, and sovereign debt.
Industry insiders say there are three players in this market that offer the full spectrum of credit derivatives products, including forward agreements, total return swaps, default options and others.
They are J.P. Morgan & Co., CIBC Wood Gundy Securities Corp., and CS Financial Products.
The complexity of the transactions has been a drag on the development of the market. Also, banks to some extent may be leery because of previous derivatives investments gone sour.
"It's a new product with a legitimate use, but introduced in an envorinment where financial innvoation has been under attack," one banker.
The notional amount of credit derivatives outstanding is $39.2 billion, according to CIBC Wood Gundy's estimate. By comparison, the Bank of International Settlements estimated that the average daily notional volume of interest rate swaps worldwide amounted to $63 billion during their April 1995 survey.
Still, hopes are high that these products will ultimately deliver not only large banks, but also small, local banks from a perennial problem: concentration of credit exposure.
"In the same way that small banks are now able to use interest rate swaps to hedge interest rate risk, there is no reason to believe they couldn't use credit derivatives to hedge their credit exposures," said Blythe Masters, head of credit derivatives at J.P. Morgan.
Ms. Masters said these instruments provide banks and other lenders with a mechanism to transfer credit exposure from those who have it but don't want it, to those who want it but don't have it.
Banks' increased focus on risk-adjusted return on capital is accelerating the market's development, said Shaun Rai, head of credit derivatives with CIBC Wood Gundy. He said credit derivatives are fundamentally changing the way banks price and manage their credit risk.
"As more banks are focusing on their risk-adjusted rates of return, it is making them think more about the need to dynamically manage credit risk," he said. "Credit derivatives are enabling banks to separate the credit decision from the ability to fund that risk effectively."
Like other derivatives, credit derivatives give investors the ability to split out and sell specific risks, said Heinz Binggeli, a managing director at Emcor, an Irvington, N.Y., risk management consultant.
"As long as you have parties with a different perception of what the risk really is, you have a market," he said. "If I buy a certain piece of paper but I don't want the credit risk associated with it, there is someone on the other side who may say they like the credit risk with the right compensation."
Currently, the biggest buyers of these exposures are hedge funds, said Hal Holappa, a director who is responsible for credit derivatives marketing for CIBC in the United States.
Another big market is currently with banks looking for new sources of liquidity for their loan portfolios, said Sarah Lee, who markets the instruments to financial institutions for CIBC Wood Gundy.
"This is really a macro way of dealing with different credit portfolios within the bank," she said.
Key to the full development of this market, though, is liquidity. Until recently, dealers have complained of a dearth of counterparties willing to accept the specific credit exposures offered by these products.
Banks can help their own cause in this instance, Ms. Lee said.
"If credit derivatives provide another tool to manage credit risk better, it behooves banks to help this market grow," she said.
The credit markets in general are creating a situation ripe for the development of these products, Ms. Masters said. First, the squeeze on interest margins is forcing banks to look for ways to reduce their risk and enhance returns. At the same time, a lack of supply in the bond markets has investors anxious for this kind of product.
Not willing to take chances, derivatives dealers are increasing their efforts to educate potential customers, some of whom have begun buying and selling derivatives. Still, a great many remain on the sidelines.
"Credit derivatives are the most talked-about product in the derivatives world,"said Ms. Lee. "They are also probably the least-executed product, but they've got the most potential."
