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The climate for credit derivatives

01 November 2001  |  152 views  |  0

The mid-nineties heralded the separation of credit funding from allocation of risk. But how far have credit derivatives lived up to their promise and does the technology exist to support them, asks Tom Kozlowski, CEO, City Practitioners Ltd

There are several ongoing issues that have stymied the development of credit derivatives. Lack of a universally-accepted definition, no single body to oversee disputes and concerns about risk exposure transparency have all added to a reluctance by some financial services organisations to use them. As a result, the development of underlying technology supporting credit derivatives has progressed more slowly than in other banking industry areas. But this looks likely to change.
One of the major reasons is that the use of credit derivatives is beginning to climb. According to the Bank of England, the notional principal outstanding is probably approaching $US trillion globally. And the British Bankers Association says the credit derivatives market has grown from an estimated $40 billion outstanding notional value in 1996 to an estimated $740 billion at the end of 2000.
This increase is being driven by various developments in the banking industry, not least by the push for transparency. Other key factors include the need for banks to:
· Diversify their risk portfolio, which is particularly important in a recession or slowdown to limit exposure to individual market sectors
· Achieve straight-through-processing (STP) to improve efficiency and cost-savings
· Demonstrate to regulators that they meet capital adequacy requirements
· Ensure an integrated, single view of investment and risk
As our current economic situation worsens, exposure to credit risk grows and the use of financial instruments such as credit derivatives is increasing. This has coincided with growing pressure in recent years for financial institutions to automate and integrate all their applications and processes to meet regulatory requirements, minimise risk and keep pace with technological innovation.
Recent market developments
Although not widely used, the advent of online credit derivatives trading exchanges such as Creditex.com, CreditDimensions.com and CreditTrade.com is a significant indication that the market is growing.
The exchanges are backed by major players. Creditex, founded in April 1999, for example, has equity investment and support from Deutsche Bank, J.P. Morgan Chase and Bank of America among others while CreditDimensions’ eclectic mix includes Algorithmics, Bureau van Dijk Electronic Publishing (BvD) and Standard and Poor’s. Chase Manhattan Bank and Internet Capital Group are among the supporters of CreditTrade.com. And a new entrant, ePrimus.com, is expected to join the fray later this year, intending to act as a creator and investor by selling credit protection in the form of default swaps on more than 1,500 investment-grade names.
These online exchanges also highlight the need for integrated systems, particularly as banks are notorious for the number and diversity of platforms and applications used.
Integration interlude
In the past, financial organisations have relied on spreadsheets to record credit derivatives transactions. And for most this is still the case. Yet as STP and risk management become even higher on the agenda, so too does the push for technologies that can effectively automate and manage transactions. Banks must ensure that all processes are fully integrated and that back and middle offices can keep pace with front offices. However, given the plethora of proprietary trading platforms used by banks, offerings must be easily designed, built and integrated into core systems to be a worthwhile investment. Electronic initiation, execution and settlement is essential. It is therefore crucial that any credit derivatives solution is:
· Open
· Scalable
· Stable
· Flexible
· Easy to integrate
· Future proof
Credit derivatives software today
So what’s on the market so far? Some vendors are pushing end-to-end solutions while others are focusing on packaged, component-based solutions, which can be ‘bolted on’ to core systems. And other vendors say their solutions can be bought as a standalone module or as part of a suite.
Leading players so far include Front Capital, Murex, Summit, SunGard and Savvysoft. The US companies appear to be benefiting from first mover advantage in the UK marketplace at this stage. Current suppliers tend to be global organisations with an HQ in New York. One exception is Front Capital Systems, which has an office in London as well as New York, Stockholm, Frankfurt, Zurich and Johannesburg.
Many of the vendors are pushing front-to-back-office solutions covering cash and derivatives trading as well as FX, energy and commodities, equities and interest rates. FRONT ARENA, from Front Capital Systems, for example, combines fixed income, asset swap and interest rate derivative capabilities with credit derivative functionality. With high-yielding securities and credit derivatives in the same system, monitoring all positions simultaneously becomes easier.
Some vendors, such as Murex, offer a suite of integrated front and back office systems sharing the same middle and back office platform. The solution offers integrated, front-to-back office software solutions for cash and derivatives trading and processing in FX, energy and commodities, equities and interest rates. This includes listed, over-the-counter (OTC) and exotics derivatives on securities and FX.
Summit’s credit derivatives module can be run as a standalone application or as part of a product suite and supported instruments include credit swaps, credit-linked bonds, risky bonds (theoretical valuation) and forward bonds purchase (binding and non-binding). Features include default probabilities and recovery rates.
Vendors including SunGard and Savvysoft have created component-based offerings. SunGard’s Credit Derivatives Components module provides a ‘building-block’ asset, allowing any possible credit derivative product to be structured and managed in a portfolio.
The module aims to offer staff the ability to structure, price, analyse, trade and risk manage a variety of credit derivative instruments. It supports several credit derivative instruments, including credit default swaps, credit spread options and total rate of return swaps. The functionality includes the ability to:
· Touch - Pay/receive par amount at the time a credit event occurs
· End - Pay/receive par amount at the end of the contracts life if a credit event occurs
· Annuity - Pay/receive a fee from the time a credit event occurs until the maturity of the contract
· Fee - Pay/receive a fee from the start of the contract until the first of either a credit event occurring or contract maturity.
And risk management is not forgotten. The solution emphasises the importance of analytical integrity and the ability to support enterprise-wide risk management. It includes risk measures for credit derivatives commensurate with other interest-rate sensitive instruments such as bonds, caps and swaps. This means that risk can therefore be aggregated across asset classes and/or on a portfolio or enterprise-wide level. There is also an option to produce specific credit derivatives reports.
Savvysoft’s TOPS suite of products comprises nearly 70 OTC and exchange-traded derivatives models. Savvysoft’s newest product, TOPS Credit, is geared to handling many types of credit derivatives, including total rate of return swaps, credit default swaps, credit linked notes, credit spread options and others. Like Summit, Savvysoft takes default probabilities into account. In addition to letting the user specify the probability of an issuer default, TOPS Credit can also base its calculations on the probability of counterparty default and the correlation between these two probabilities. The probabilities include functions of time, interest rate levels and stock price levels to give users control over credit derivatives valuations.
Huge opportunity
The credit risk transfer market has the potential to increase the overall robustness of the global financial system over time. But to do this, it is essential that financial institutions can rely on a stable, scalable, flexible solution that can be easily managed and integrated into core systems.
The growing popularity of credit derivatives will offer IT vendors an opportunity to extend their reach within financial institutions. But we are currently at the early stages. The credit derivatives instrument is still in development and the market is wide open for technology vendors – particularly UK-based suppliers – to enter. This is an emerging market and we have a long way to go before we know who will be the leader in this space and how it will develop.

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