A lot of people, including many regulators, fear that a breakdown in the global derivatives market is inevitable, a breakdown that could threaten the world financial system. With nominally trillions of dollars in these often complex contracts floating around the globe, people are very worried.

And problems do crop up. The most infamous was the collapse of Long Term Credit Management in 1998, which truly put the system at risk. But disaster was averted, thanks in large part to intervention by the Federal Reserve.

The latest threat, although not as dire as LTCM because it involved credit derivatives and credit derivatives represent a small niche, arose last year when financially ailing Conseco Inc. was forced to restructure its debt. Some of Conseco’s creditors (many of them banks) had used credit derivatives to protect themselves against loss, and the question arose whether the restructuring was a credit "event" that should have triggered payment by those who sold "credit protection" under the derivatives.

The dispute raised tempers across the financial markets, as some market makers in credit derivatives refused to acknowledge the events surrounding Conseco’s debt as a "restructuring" credit event while others did. The result was a drop in liquidity in the credit derivatives market.

This time there was no intervention by regulators, and the issue was worked out through negotiations within the International Swaps and Derivatives Association, a trade group. To the relief of the markets, those negotiations concluded successfully last month, with the parties within the ISDA having reached a consensus.

"Some regulators have been afraid that more dreadful issues will pop up [in the credit derivatives market], but what’s striking is that the dealer and user communities have been able to work it out so far," says Rebecca Simmons, a partner in the law firm of Sullivan & Cromwell, and an expert on derivatives.

Credit derivatives are among the trickiest to deal with. They still account for a small part of the market, but volumes have grown to some $1 trillion in notional value over the last seven or eight years, according to Vinod Kothari. Kothari, who is based in Calcutta and publishes a newsletter on securitization and credit derivatives at www.vinodkothari.com, says credit derivatives are the fastest growing segment of the over-the-counter derivatives market.

The market is very young and still is grappling with growing pains, as was shown recently by the restructuring of the debts of Conseco.

Banks had loans to Conseco, and some had bought "credit protection" through derivatives contracts. During the restructuring negotiations, the bank loans were restructured in such a way as to improve their credit quality; for example, more collateral was put behind them. Not all creditors got as good treatment, and the quality of their credits remained relatively poor.

In this dog-eat-dog world, some banks felt they could make a killing as a result of the credit protection they had bought under their derivatives contracts, and claimed that the restructuring was a credit event, although the quality of their own credits to Conseco actually had improved.

Under the derivatives contracts, the holders of credit protection, when claiming a loss due to credit quality, must deliver Conseco loans or debt securities to the sellers of credit protection in order to receive compensation for the decline in credit quality. [At times, they are "cash settled," which means the debt securities or loans are not actually delivered, but a selected debt security or loan is used to calculate a cash settlement amount.]

But those loans need not be the ones the banks hold in their own portfolios. They could be any Conseco loan or other debt securities of Conseco. As a result, banks could buy poorer quality credits in the market (debt securities or loans that had not been restructured), and demand that the credit protectors pay up. The banks could still have been holding the better-quality Conseco loans in their own portfolios. It appears that Conseco’s bank creditors that had purchased credit protection derivatives had bought longer-term, poorer-quality debt obligations in the market for delivery to those who had contracted to provide credit protection.

"There was a great hue and cry in the credit derivatives market," said one participant, "with the credit protection sellers saying it was an outrage and not consistent with what was meant."

In the end, a consensus was reached within the ISDA, providing a workable guideline. The group’s new supplement would in certain circumstances, "limit the maturity of the obligations that are deliverable after the occurrence of a restructuring credit event, thereby limiting the so-called cheapest-to-deliver option that has caused problems following recent restructuring events," according to an ISDA press release.

"The new provision represents common ground on this issue and the greatest potential for broad market consensus on the restructuring issue," says Robert Pickel, ISDA’s executive director and CEO. "This reflects a concerted effort to achieve enhanced default swap liquidity across the market."

Kothari points out that even as the Conseco controversy struck U.S. markets, Europe, which is a more active credit derivatives market, saw two of its leading players—UBS and Deutsche Bank—entangled in a technical row. Swiss-based UBS sued Germany’s Deutsche Bank for $10 million in a default swap transaction related to the debt of U.S. building materials company, Armstrong World Industries Inc. Although the parties settled before the issue actually went to court, the controversy brought to the fore the uncertainties and risks inherent in the credit derivatives business.

"Some participants in this market may not fully understand, or have differing understandings of the transactions into which they have entered; and uncertainties remain about how the courts in some countries would treat these agreements," David Clementi, deputy governor of the Bank of England, said this past March in commenting on the UBS/Deutsche dispute. Clementi was referring to the infirmities of the market’s infancy. It is difficult to say he was wrong.

With the latest consensus on restructuring issues now official, Kothari expects the credit derivatives market to continue its rapid growth. He believes the issues that faced the credit derivatives market during past year or so are merely signs of an evolving instrument heading towards maturity and clarity, not of chaos and destruction.


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