The credit derivative market could mushroom to $1 trillion in the next five years, according to Greg Whittaker, managing director and head of global credit derivatives at Chemical Bank.
Mr. Whittaker said the boom should occur as investors realize the value of hedging credit risk and regulations governing the financial instruments become more certain.
"The driving force affecting the value to the market is that investors realize that credit risk can be managed - and that it is valuable to be managed," said Kansas City Federal Reserve Bank economist Robert S. Neal.
Credit derivatives were created a couple years ago as a way for banks, financial companies, and investors to hedge their exposure to credit quality. Today, estimates of the size of this market range up to $40 billion.
Mr. Neal, in an article on credit derivatives in the Kansas City Fed's second-quarter economic review, said a major challenge to growth in the use of credit derivatives is the uncertainty of the regulatory environment.
"Should credit derivatives be treated as securities, commodities, swaps, or insurance products?" he asked. The answer, he noted, will determine which federal agency regulates the product.
Another question is how much capital must back credit derivatives, according to Mr. Neal. Although a credit derivative may reduce a bank's credit risk, he said, the institution's capital requirements may increase to cover the risk of counterparty default.
Credit derivatives include credit swaps, which involve one bank swapping the payments from some of its loans for payments from another institution, thereby reducing its reliance on a single industry or region. Others include credit options - similar to stock options - and credit- linked notes, a combination of a regular bond and a credit option based on a specified key financial variable.
Mr. Coplan writes for the Medill News Service.