Credit derivatives: adding to risk, or reducing it?

The rapid growth of credit markets has raised concerns over their impact on financial market stability. Do they add to, or reduce, market risk? The IMF's latest Global Financial Stability Report, published yesterday, devotes a whole chapter to the question.

In Chapter 2, The Influence of Credit Derivative and Structured Credit Markets on Financial Stability (PDF), the IMF authors appear to hedge their bets. On the one hand, they argue that credit markets "improve financial stability" by transferring credit risks from banks to other investors, and hence disperse risk:

Credit derivative and structured credit markets help to improve financial stability by facilitating the dispersion of credit risks. These markets allow banks, especially systemically important institutions, to shift credit risk to a broader set of investors. As a result, the vulnerability of these institutions, and of the broader banking system, to credit shocks should be reduced.

Some observers, while acknowledging a banking sector gain, are concerned that such markets may have simply shifted credit concentrations elsewhere in the financial system. However, based on the data available, there is no evidence of increased credit concentrations among regulated entities, such as smaller or regional banks, insurance companies, pension funds, or mutual funds, as a result of these risk transfer markets. As such, future credit losses are likely to be more broadly distributed, and individual losses less likely to cause a policy concern for a particular sector.

But they also acknowledge that credit derivative and structured credit markets "do present new risks and vulnerabilities". Secondary credit markets are incomplete, can suffer from poor liquidity, and may be prone to what they politely dub 'liquidity disruptions':

In many respects, the financial stability gains noted above relate to the “primary” risk transfer market, where the seller of risk, often a bank, is transferring risk to a potentially better “warehouser” of risk. The ability to tailor and package increasingly specific risk has supported the growth of this risk transfer activity. However, these markets would be more complete, and financial stability enhanced, if a more liquid secondary market were to develop in a number of market segments. The potential for secondary market liquidity disruptions, often related to the homogeneity of market participants in a particular segment and to gaps between real and perceived liquidity, remains a stability concern.

It is unclear just how likely such 'liquidity disruptions' are. But considering the low levels of liquidity in many secondary credit markets - "in part because of the buy and-hold nature of important investors, such as insurers and pension funds" - and their growing complexity and 'bespoke' nature, the chances could be quite high.

There is also a regulation problem. Credit markets are new, complex and growing rapidly. Many back offices can't keep up, let alone financial regulators, who appear to have a poor handle on the real extent of credit risk. The chapter cites "the mounting backlog of unconfirmed trades", delays or incorrect notification procedures for reassignments ('novations'), and "the need to improve settlement procedures". Despite IMF reassurances, then, it seems clear that lingering concerns over credit markets won't be dispersed anytime soon.

Comments

[cb]

Actually, unconfirmed trades are going down. The Fed got all the big boys in a room and made them get to work on it.

[joseph mushayi]

Credit derivatives are new or non existant in developing countries like Zimbabwe.How can these risk transfere instruments be established in these countries with declining GDP figures and weak economy with high political instability and the world's highest annual inflation rates above 1000%?

[smancy]

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[Charlie Mann]

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[Charlie Mann]

Do you have any other articles or info on credit derivatives pricing or trading? Been looking to find out more info on the player in the market... I've some interesting information on the following sites:
http://www.cdscawley.com
http://cdsaxiom.com

Know where I can find any additional info on the other players?

[Lafayette]

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