Two and a half months after the bottom fell out of the Russian economy, credit derivatives face their first real test as an effective risk management tool.

Lawsuits are beginning to trickle in over unpaid forward currency contracts and over credit derivatives that were bought as insurance against devaluation of the ruble and a Russian government default.

The payoff on as much as $10 billion of credit risk derivative agreements depends on when and how much of the Russian debt is repaid. With more than $150 billion of credit derivative agreements across the globe, Western banks, securities dealers, and investors are watching closely to see how the fledgling financial instrument will hold up under the Russian stress test.

Credit derivatives let lenders and bond investors isolate and hedge their exposure to credit risk. The instrument derives its value from the risk that some underlying bond or loan will not be paid in full when it comes due. By isolating and managing this risk, credit derivatives are crucial to improving capital market liquidity and efficiency, especially in the more volatile emerging markets.

Two basic structures of credit derivatives are used in Russia. The first, credit swaps, let Western investors get the higher returns on Russian bonds while insulating themselves from the risk of a government default, or so they thought. Similar to insurance, credit swaps required investors to pay a sum to a securities dealer in return for the dealer's promise to pay a specific sum if a specific credit event occurred. In the Russian debt crisis, Western investors will be looking to collect on this insurance.

The other type of credit derivative, structured notes, combines a credit swap with a conventional bond or note. Instead of making a separate payment if a credit event occurs, the credit swap pays off by reducing the amount the issuer of the note must repay. Thus, investors in these notes will get less from the banks or dealers who issued them, depending on a variety of factors, including how the swap was designed and the pricing of the underlying instrument.

Innovative financial products often raise new legal and regulatory issues, and credit derivatives are no exception. Few if any of the more common derivatives have been put to the test in the manner and scope that Russian-risk credit derivatives seem likely to be. Disputes are sure to arise over interpreting the documentation, who owes what to whom, and whether anything is owed at all.

Credit derivatives require effective legal documentation to spell out the rights and obligations of each counterparty. But the International Swaps and Derivatives Association has only recently developed standard documentation for credit swaps. Nonstandard language is the norm in many Russian-risk credit derivative agreements. This will undoubtedly lead to disagreements over several points:

Whether, when, and how a credit event has occurred. If the definition of a credit event is not precise, there will be disputes.

Whether the terms of the derivative agreements are inconsistent with the underlying bond or loan agreements.

Whether issuers and investors, wary of the negative press coverge that derivatives have gotten, entered contracts that used alternate terminology. Calling a credit swap a "guarantee" can have legal consequences.

Disputes will also arise over netting, when the credit derivative counterparties seek to convert their individual obligations into a single net obligation from one party to another after one of the parties defaults. Though the ISDA has developed closeout-netting provisions, netting is not available in every jurisdiction.

Pricing is also a major issue. Pricing credit derivatives is more difficult than pricing other types of derivatives because credit risk is not priced separately in the capital market. Instead, it is an important element that affects the value of virtually all debt and equity securities but to varying degrees.

The pricing of credit risk is built into the pricing of these securities. However, extracting the price of credit risk from the price of the security can be daunting. With Russian bonds quoted at a tiny percentage of their face amount, Russian-risk credit derivative losses are likely to be substantial.

The stage is set for widespread disputes to arise once the Russian government announces a debt restructuring. A lot is at stake. Market participants across the globe need to examine their efforts to hedge their credit risk exposure in all foreign debt markets.

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