Credit derivatives represent only a tiny sliver of the derivatives market, but they're suddenly a hot topic on Wall Street.
Created five years ago, credit derivatives enable banks to price risks in loans or bonds and sell the risk to third parties.
Regulators are fretting that the new instruments might unexpectedly spread risks previously confined to the banking system. Meanwhile, advocates say they present an attractive alternative to loan syndication as individual banks try to solidify relationships with borrowers in an increasingly competitive lending market.
"Selling a portion of a loan can alienate clients," observed Blythe Masters, vice president at J.P. Morgan & Co. "Credit derivatives enable banks to eliminate the risks they don't want without jeopardizing relationships."
Traders note that bankers, prodded by federal regulators, are investing heavily in technology to identify and measure risk. As reliable measures of risk are developed, it becomes that much easier to create and market the credit derivatives, which are contracts between the banks and third parties willing to assume, for a price, some of the risk of a loan.
"We're in discussions with maybe 20 regional banks, and I'd say the conversations are deep with maybe half a dozen of them" that are interested in using the instruments to manage lending risk, said Shawn Rai, head of credit derivatives trading at CIBC Wood Gundy.
One sign of the growing interest in the instruments was a well-attended conference in New York this week, sponsored by International Communications for Management. Another sign is a new regulatory requirement that banks include more credit derivatives information in their public financial reports, starting with the quarter ending June 30.
The Office of the Comptroller of the Currency has said it is concerned that new risk-management tools may merely transfer lending risks to derivatives buyers who may not understand the intricacies of the contracts.
The regulator has at least three concerns. It wants to monitor big banks' trading of the instruments. It wants to see if smaller banks may be taking on new risks by investing in them. And it wants to know if banking risks are spreading outside the banking system as nonbanks participate in the contracts.
The traditional method of reducing exposure to the risk of a large loan has been to syndicate the loan-that is, divide the loan among several banks.
The aim of credit derivatives is the same, in that they would disperse lending risk. But advocates say the derivatives are preferable to syndication in at least one respect: The credit derivatives enable banks to sell off the risk in their portfolios without telling the borrowers. That's because the third party is not lending money to the borrower, but merely accepting the risk. The contract remains a secret between the lender and the third party, and the lender does not risk offending the borrower.
While the use of private contracts may have great implications for how banks manage and profit from risk, so far this infant market is being nurtured solely by a handful of money-centers and brokerages.
Credit derivatives represent 0.1% of the total notional value in all over-the-counter derivatives, according to a recent survey by the British Bankers Association.
What's more, it is unclear just who is buying and selling credit derivatives and how much, although Citicorp said in its 1996 annual report that it was holding $1.9 billion worth, up from $300 million in 1995.
Although most kinds of derivatives attract a wide variety of users, the British Bankers Association in its report predicted banks will dominate the credit derivatives market "given their knowledge and experience of credit risk and credit products."
That day may come, but for now bankers at many regional banks have peered into credit derivatives and decided there are more appropriate ways to manage risk.
"We've looked into them, but we haven't done anything," said John Ward Logan, executive vice president at First American Corp. in Nashville. The market, he said, is simply too small to offer the swaps his $10 billion- asset bank is looking for.
Like any fancy new product, credit derivatives are expensive. The contracts must be specifically tailored to each party's needs. And because few banks are involved as sellers or users, the bid/offer spread is as high as 25 basis points, traders say. By comparison, spreads on a standard interest rate swap have narrowed to as little as 1 basis point.
Still, traders are hardly discouraged. They point out that it took several years for interest rate swaps to catch on, and traders and their marketing teams are pounding the tables to get banks to appreciate the power of their new toy.
Bankers may be reluctant to enter the fray because, some traders say, the credit derivatives market is still a pretty speculative place.
"The market was originally developed for creation of credit risk hedging," said Barry Seaman, vice president at General Re Financial Products. "However, it has evolved into a mechanism for investment and risk management products."
Still, credit derivatives seem likely to grow, especially among American banks that lend in emerging markets, where credit quality is always a concern.
But probably the best reason credit derivatives have a big future is the money banks can make unwinding the legal, tax, and regulatory risks inherent in every loan or bond.
"If you take a bundle of risks and auction them to an audience, you can probably get a higher overall price," Ms. Masters of J.P. Morgan said. "The sum of the parts is better than the whole."