The expansion of the investor pool and the rapid growth in the number and variety of credit derivatives available are prompting calls for stricter regulations.
As the race to list the first credit contracts on the worlds financial exchanges intensifies, regulators are under increasing pressure to impose tighter constraints on the market. While one of the main challenges for the exchanges and their partners will be defining the specifications of the contracts, a bigger concern is the risk that investors will be taking. The much publicized corporate failures of the past few years have only added to the general awareness of the risks involved in credit derivatives, many of which are still only partially understood by all but a handful of major players.
Some of the more significant advances in terms of regulation have been the work of the International Swaps and Derivatives Association. ISDA established standardized Master Service Agreements for credit derivative contracts and now operates in 39 countries. Prompted by the need to improve legal documentation for derivatives trades, the ISDA established exact definitions of a forward asset, what constitutes a credit event or default, and limits to size and duration of transactions.
Unfortunately, many trades are cross-border, and a number of national regulators are concerned that the ISDA rules are inadequate. They are looking into creating their own rules, triggering concern among the major banks that these groups will lag behind the market, resulting in rules that are out of date before they are even implemented.
Investor Base Grows
Credit derivatives have only recently attracted the attention of national regulatory bodies. This is mostly because the market was traditionally the almost exclusive realm of the major investment banks, and the number of credits was small. In 2004, however, it is expected that insurance companies will be the single largest participant in the market, with hedge funds also playing a major role. The past two years has also seen an increase in uptake among retail investors.
This expansion of the investor pool and the rapid growth in the number and variety of credits has led to concern that the new holders of such instruments may not have a clear understanding of the risks they are taking.
Some believe that increased laws may be rendered unnecessary, however, by the new International Accounting Standards (IAS), which may do the regulators work for them. The new provisions will oblige corporates, banks, insurance companies and most other entities to analyze and fully account for exposure to credit derivative risk on their financial statements.
This should lead to improvements in evaluative systems and greater understanding of the derivatives markets. Other changes to disclosure laws taking place across Europe and North America should lead to more information about the underlying credits behind the derivatives becoming available.
Douglas Long, product marketing director at Principia Partners, says any increase in transparency and liquidity will assist growth of the market. The more data available, the greater the pool of potential credits, which will in turn lead to more liquidity and more complexity and opportunity for the derivatives markets, he explains.
It seems that if the aim of the regulators is to limit complexity and ensure that products are available to the widest possible audience, they may need to reconsider their approach.