Compromising Positions

Will credit derivatives encourage more lending, or will they harm the interests of borrowers?

But Watkinson says that such volatility may be a temporary phenomenon as the growth of credit derivatives adds liquidity to the credit markets. That liquidity would take the form of capital from an increasing number of market participants. The extra liquidity, she says, “could more than offset the volatility.”

Conflicting Interests

Even if new liquidity offsets added volatility and banks don’t substitute sales of swaps for loans, there is reason to worry about the proliferation of credit derivatives, because they have the potential for abuse. Credit derivatives are publicly traded, which means that it’s possible that the trading side of the bank could receive nonpublic information from the lending side.

That prospect prompted Chris Dialynas, a managing director at investment firm Pimco, to publish a white paper last October on the potential for abuse. Warned Dialynas: “Credit-default markets are a mechanism with which friendly commercial bankers… can profit by betraying and destroying their clients through the use of inside information.”

Alarmist? Not to market participants, who responded by creating a system for exchanging information about practices for preventing insider trading on such information. Those practices essentially amount to maintaining a Chinese Wall between lending officers and traders.

“This is a very serious topic and an evolving issue. A perception of unfairness is damaging to the business,” says JP Morgan’s Masters. “The [Pimco] paper helped prompt me and others to make sure the industry responded in an appropriate way.” In May, that group released a paper that lays out guiding principles for compliance with insider-trading laws.

Dialynas, for his part, believes “there appears to be less trading on inside information today.” However, he maintains that self-policing won’t eliminate the potential for abuse. For that reason alone, finance executives need to pay closer attention to how the credit-derivatives market is evolving. “It should be the duty of every corporate treasurer to track the market pricing of its credit derivatives,” says Jeff Wallace, managing partner at Greenwich Treasury Advisors, in Greenwich, Connecticut.

That’s not an easy task right now. Among other things, pricing data is not easily available, and banks and other participants do not disclose how credit derivatives alter their risk profiles. “Lack of transparency in the market is the major hindrance to the market’s growth,” says Fitch’s Grossman, “and it has to be addressed.”

Yet some treasurers contend the task of monitoring the credit-derivatives market isn’t all that daunting. “It’s a matter of understanding the interplay of those who use the credit-derivatives market and why,” says Christine McCarthy, treasurer at The Walt Disney Co. “The credit derivatives shouldn’t come as a surprise if you put all the pieces together.”

Too Much of a Good Thing — or Too Little?

Credit derivatives were born in the early 1990s from the financial world’s insatiable desire to lay off risk. Of course, banks could already do that by distributing loans through investment syndicates. But by buying credit derivatives, lenders could hedge some or all of their corporate exposures without such syndicates.


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