Unsurprisingly, commercial banks are the largest players in the CDS market. According to figures compiled by the British Bankers’ Association (BBA), banks accounted for 52% of the protection buyers market and 39% of the protection sellers market in 2001. The BBA expects both these shares to drop by 2004, to 47% and 32% respectively. That would still make banks dominant in the market for protection buying, but in terms of protection selling they would be overtaken by insurance companies, the share of which will remain steady at 33% in 2004 – identical to their share in 2001, according to BBA forecasts.

Benefits for banks

For banks, one of the most important benefits of credit derivatives in general – and credit default swaps in particular – can be traced back to 1988 and the publication of the Basel Capital Accord which forced many lenders to reappraise the size of their exposure to corporate borrowers, many of whom would have been long-standing customers. For lenders, this presented an obvious conundrum: how could they reduce their exposure (or simply leave their exposure static) to borrowers with whom they had developed close links dating back many decades without seriously jeopardising those relationships? The CDS market provides a valuable solution to that dilemma.

For banks with limits on their credit lines to individual borrowers, the credit default swap market is an effective means of transferring risk on outstanding loans without physically removing assets from the balance sheet. Granted, there are alternative means of offloading these assets via, for example, the secondary market for syndicated loans. But in the European loans market, secondary trading has yet to take off in a meaningful way. Even if there was a liquid and flourishing market for secondary loan trading in Europe, in many instances loan documentation prohibits lending banks from passing their exposure on to third parties in this way. And even if documentation includes no clause preventing a lending bank from subsequently offloading a facility, the process of selling loans in the secondary market can be one that entails considerable legal and administrative costs for the banks involved.

The most powerful incentive for lending banks to use the CDS market as a means of transferring the risk on their loan books, however, is that it allows them to do so without the knowledge of the borrower. This in turn allows them to free up additional lending lines for prized customers that may be very important sources of ancillary business in, say, corporate finance.

lternatively, CDSs can be used as a means of reducing banks’ concentration in individual industrial sectors or geographical regions. Use of the CDS market can therefore help banks to promote as well as to maintain their client relationships, allowing them to open up new credit lines that might otherwise have remained closed.

Room for growth

Even though commercial banks are the most active participants in the CDS market, it should be noted that even in the US, where the credit derivatives market is most developed, the market remains dominated by a handful of the largest banks, with JPMorgan, Citibank and Bank of America accounting for the lion’s share of activity. According to OCC statistics compiled in the second quarter of 2002, fewer than 400 of the 2,200 institutions under its supervision held credit derivatives. That suggests that there is room for considerable growth among bank users of the market in the US.

In Europe, according to a report released in March 2003 by the rating agency Fitch, banks have been net buyers of protection via the credit derivatives market to the tune of some E65bn, although only about 30% of European banks active in the market are protection buyers. The report observed that German Landesbanks have become very active players in the CDS market, largely as sellers of protection, although they are by no means alone in this respect.

“The conventional view is that banks are primarily net buyers of protection,” the Fitch report notes. “Nearly three-quarters of the banks surveyed are net sellers. The banks are using credit derivatives as an integral part of their revenue-generating business, enabling certain European banks to diversify by gaining exposure to regions and sectors where they are underweighted.”

Other sources confirm that European banks’ overall use of the CDS market remains limited, but is growing rapidly. According to a report published in January 2003 by the working group established by the BIS Committee on the Global Financial System: “Although the scale of their current involvement in CRT [credit risk transfer] differed greatly across the banks interviewed by the Working Group, almost all stressed its importance and expressed their intention to step up their activities in this area.”

However, the same report adds that in total, “the number of institutions actively involved across the range of CRT markets remains quite limited at present. While, for example, the use of ABSs has become more widespread within the banking industry of some countries, the number of institutions using CDSs on any scale is still relatively small.”

A number of commentators, including the rating agencies, have voiced misgivings about banks’ relatively poor disclosure of their precise exposure to the credit derivatives market. For example, an analysis of the annual reports of 30 banks in 10 countries by the BIS working group found that none of these made “comprehensive disclosures”. That, adds the report, “may give grounds for concern”.

Conflicts of interest

Another cause for concern about the role played in the CDS market by commercial banks that are active participants in the syndicated lending market is the potential for conflicts of interest among these lenders. Some newspapers have alleged that Chinese walls between banking and trading desks have been broken, with lenders privy to much more comprehensive information about their borrowers than investors in the capital market or sellers of protection in the CDS market.

Investment banks

Investment banks are also active participants in the CDS market, both as providers of liquidity for their customers and as proprietary traders. The CDS market can offer a highly efficient means of removing assets from the balance sheets of investment banks, an objective that has become more and more important in recent years as the leading investment banks seek to offer a ‘one-stop shopping service’ to their corporate clients. Given the relatively limited size of investment banks’ capital, the CDS market provides them with a useful means of demonstrating their commitment to corporate clients by supporting syndicated lending facilities without exerting unsustainable strains on their balance sheets.

Insurance companies and other investors

Insurance companies’ participation in the CDS market, predominantly as sellers of protection, is on the up. While many insurance companies will provide protection as writers of single-name default swaps, they are also active in the market as buyers of CDOs and credit-linked notes (see page 28).

It is important, however, to differentiate between the different types of insurance companies active in the CDS market. Life assurance companies, for example, act as an important source of investor demand for ABSs and CDOs. US monoline insurance companies, meanwhile, are pivotal players in the CDS market, often as sellers of credit protection on the senior (or so-called ‘super senior’) triple-A rated notes in structured portfolio transactions.

Barriers to involvement

A number of insurance companies prohibited from entering into derivatives transactions directly, meanwhile, have addressed this problem by establishing subsidiaries known as transformers’ functioning largely as sellers of credit protection, based in offshore locations, with Bermuda the most popular in this respect.

Other mainstream institutional investors, such as pension and investment funds, are less active players in the credit derivatives market. In part, this is because a substantial number of institutional investors in Europe are unable to trade credit default swaps, maybe as a result of direct regulatory prohibition or a lack of the necessary back-office infrastructure or expertise. Demand for skilled credit derivatives technicians comfortably outstrips supply, explaining why derivatives specialists are now among the best-paid professionals in financial centres such as London. For all but the largest institutional investors, recruiting experienced teams of derivatives experts remains a prohibitively expensive exercise.

The German Banking Act, for example, restricts German mutual funds from using credit derivatives, while swap contracts and over-the-counter derivatives also remain legally out of bounds for mutual funds in a number of Scandinavian economies. An exclusive survey of 32 credit asset managers in Europe, the results of which were published in the October 2002 edition of Credit, offered valuable insight into the extent to which fund managers remain restricted from trading CDS contracts.

From the survey’s respondents, 22% indicated that they were permitted to invest in CDSs under their current investment mandates, while 28% said that although they were not yet allowed to trade CDSs, they expected to be able to do so within the next 12 months. A further 16% expected to be active in the market within two years, with the remaining 34% unsure as to when they would be free to trade CDSs.

But the response to the survey suggested that there is a high awareness of the value of the CDS market even among those institutions that are not yet active in the sector – 10 of the 32 respondents, for example, said that they use the CDS market as an indicator of where prices may be heading in the underlying cash market. In the words of one investor: “We do use CDSs for research purposes, and as the market is more efficient than the cash market, it is a good indicator of where a credit is moving.”

From some other respondents to the same survey, however, came some outspoken criticism of the CDS market. One UK investor felt that “the CDS market does not have any sound economic reason for us to invest in it,” and that “it is not cheap enough. The bid-offer is too wide and the banks rip you off.” However, that seems to be a minority view and it is probable that as the CDS market develops and matures, reservations such as these – already dismissed by intermediary banks as anachronistic – will recede.

Flexibility for investors

Among those investors that are allowed to trade CDSs, perhaps one word sums up most comprehensively the benefits afforded by the market: flexibility. For example, the CDS market has proved to be an especially useful means of taking a bearish position on any individual issuer in the bond or loan market, allowing market participants to go short of credit risk by buying protection using CDSs.

As one market participant points out: “CDSs allow you to trade on a rumour”, something that the illiquid bond market and static loan market do not. But there are numerous other examples of flexibility enjoyed by investors in the CDS market. As Goldman Sachs advised in a report published in May 2001: “Investors who employ default swaps enjoy the flexibility to structure the terms of their investment, including maturity, recovery, call features and coupon type. Default swap overlays provide an efficient tool to reposition an existing bond or loan portfolio – either short or long term – to reflect changing risk requirements or to take advantage of market opportunities.”

Nevertheless, mutual funds accounted for just 2% of the market for protection buyers in 2001, according to BBA data, with pension funds accounting for 1%. Both these shares are expected to rise to 3% by 2004.

One group of investors that has become markedly active in the credit default swap market in recent years is hedge funds, with the BBA reporting that these funds accounted for 12% of the market for buyers of protection in 2001, a share that is expected to increase marginally to 13% by 2004. In the market for protection selling, the hedge funds’ share is expected to rise from 5% to 7% over the same period.

Alternative means of access for investors

For those investors that are still unable to trade credit default swaps directly, a number of proxy products have been developed by intermediary banks allowing for them to enjoy many of the benefits of exposure to the CDS market. For example, in February 2003, JPMorgan announced the launch of Credit Elect, a new derivative trading platform designed for investors unable to trade CDSs outright, “either for regulatory, credit or infrastructure reasons”.

Credit Elect is a synthetic balance sheet which provides these investors with a liquid and flexible trading platform actively to manage a portfolio of CDSs. According to JPMorgan: “Credit Elect enables the investor to build and trade a diversified credit portfolio based on the wider universe of names that trade in CDS format. The investor has the ability to go long and short the market in funded format, and trade the basis between CDSs and bonds, loans and equity.”

Other buyers of protection risk

Theoretically, CDSs can be used by a number of organisations outside the confines of the financial services industry. Corporates, for example, might use the credit default swap market as a means of insuring themselves against trading with potentially risky commercial counterparties – be it suppliers or customers.

In Europe, however, corporate use of the CDS market appears to have remained muted. According to a Bank of England report: “Judging from the Bank’s regular contacts with UK companies and market intermediaries, corporate involvement in the credit derivatives market remains limited to a handful of large multinationals. Intermediaries do, however, see potential for a number of applications as the market matures.”

Please email Matthew Attwood, Editor, to comment on this article.