More U.S. banks will use credit derivatives to hedge risk as soon as regulatory requirements for capital allocation, accounting, and tax treatment are clarified, industry sources said this week.
Bankers and analysts welcomed tentative guidelines issued earlier this week by the Office of the Comptroller of the Currency and the Federal Reserve Board on the use of these derivatives. But they also noted that guidelines still remain fairly broad, and that details have yet to be worked out.
"There are a number of issues, including clarification of regulatory treatment and potential capital allocation, which as they unfold, will affect how the market develops," said Ron Reading, a managing vice president at First Manhattan Consulting Group in New York.
Banking sources say credit derivatives will significantly improve market liquidity for loans, because they permit banks to avoid becoming overconcentrated on lending to borrowers in one geographic region or in a limited range of loans.
They also noted that the instruments will permit lower-rated banks to swap higher-yielding but riskier loans for less-risky loans.
While dozens of banks are likely to use these derivatives, analysts and bankers named Canadian Imperial Bank of Commerce, J.P. Morgan & Co., Credit Suisse, and Chase Manhattan Corp. as the biggest brokers.
Shaun N. Rai, director of financial products at Canadian Imperial, predicted Tuesday that the market for credit derivatives could double by the end of the year, from an estimated $40 billion worth of contracts currently outstanding.
He and other members of the Canadian bank's derivatives team in New York noted that the market is still mainly limited to a handful of money-center banks and branches of foreign banks, alongside hedge funds, corporations, and institutional investors.
But they added that the number of potential users is growing steadily, especially among commercial banks.
"A lot of people are looking at this market, and others will be coming in very soon," said Andre Cappon, a banking consultant with the CBM Group in New York.
Among the two most commonly used credit derivative products are total- return swaps and default put options.
Under a total return swap, which is based on a commonly agreed initial reference value for a credit, the seller pays the buyer for any increase in the value of the credit on maturity. The buyer, in turn, compensates the seller for any decrease in the reference value of the credit.
Under default options, the seller gets paid either a fixed amount or an annual payment. The seller, in turn, agrees to cover the credit if the borrower defaults or on any amount in default, but makes no payment if there is no default.
Analysts and bankers said both contracts are close to becoming standardized and will probably soon be traded on futures exchanges.
The Fed, the OCC, and Federal Deposit Insurance Corp. are all consulting with major players in this fast-growing market and with the International Swap Dealers Association.
Bankers who participated in recent discussions said the three agencies will soon separately issue their own regulations.
On Monday, the OCC and the Federal Reserve told examiners that the institutions they supervise must utilize risk management systems for credit derivatives. Both agencies said the instruments are useful risk management tools, but added that they must be treated with the same care as any other type of derivative.
Although both sets of guidelines were somewhat vague, the Fed provided a little more detail than the OCC on the amount of capital institutions should hold against credit derivatives.
The Fed recommended that an institution that enters a contract to take on another's credit risk should hold capital against that exposure as if the risk stemmed from an asset on its own balance sheet.
Mr. Cappon noted that most credit derivative contracts are still concentrated among the better credits, but he predicted that they would soon be extended to lower-rated credits.
Olaf de Senerpont Domis contributed to this article.
