Credit Derivatives White Paper

7/31/2019 Credit Derivatives White Paper

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The Corporate Use ofCredit Derivatives:

Will the Post-Crisis

Environment be a

Catalyst for Expansion?

April 2011

Whitepaper Series - Volume V

Originally published in gtnews - Jan 2011

A Structured Approach to Financial

Risk Management

www.validusrm.com


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Executive SummaryFrequently portrayed as the next big thingin corporate risk management, credit deriva-tives have never really taken o within thecorporate marketplace. Despite rapid uptake

amongst institutional users, the corporatemarket has remained reluctant to embracecredit derivatives or a number o reasons, in-cluding basis risk and accounting constraints.

Tis white paper examines the potential orcredit derivatives as corporate risk manage-ment tools in light o the increased ocus oncredit and counterparty risk ollowing thecredit crisis, and also identifes some alterna-tive applications o credit derivatives to acili-tate access to aordable sources o undingand liquidity.

A Structured Approach to Financial Risk Management


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A

n increased ocus on credit and counterparty risk has un-doubtedly been one o the main implications o the bankingcrisis or corporate treasurers. In act, the PWC 2010 Global

reasury Survey highlighted that the number o treasurers who con-sidered credit risk management o high importance has more thandoubled since beore the crisis. Tis is perhaps unsurprising, as cor-porates normally have a huge amount o credit exposure arising roma number o dierent sources, and one o the memorable lessons othe nancial crisis is that even a high credit rating is no guarantee ocontinued solvency. However, despite the signicance o credit riskto the non-nancial rm, the corporate use o credit derivatives hasremained limited, notwithstanding the signicant volume growthand product developments that have occurred in the market since its

inception in the early 1990s. It is thereore perhaps an opportunemoment to revisit the potential o credit derivatives or the corporatetreasurer, review why the corporate market has yet to really embracethese tools, and ask whether the current environment, characterizedby an increased awareness o the importance o credit risk manage-ment, will prove to be a catalyst or increased corporate demand.

While credit derivatives such as Credit Deault Swaps (CDS) and o-tal Return Swaps (RS) were rst introduced to allow banks to layo excess credit risk (resulting largely rom the counterparty creditrisk associated with interest rate and oreign exchange derivatives, as

well as normal lending operations), it was not long beore investmentbanks began marketing these products to the corporate market. Fre-quently portrayed during the late 1990s and early 2000s as the nextbig thing in corporate risk management, credit derivatives were ex-pected to ollow in the ootsteps o FX and interest rate derivatives,and become essential elements o the corporate treasurers risk man-agement toolkit. Whilst the logic behind such expectations may havebeen sound (aer all, credit risk could certainly be argued to be asgreat a risk to most non-nancial corporates as either FX or interestrate risk), this promise has not been realized to date. Despite rapid

growth in the global credit derivatives market (which rivalled the FXderivatives market prior to the credit crisis), non-nancial corpora-tions have thus ar played a negligible role in this growth. A 2009ISDA study showed that o the Fortune Global 500, only 2% o non-nancial corporations used credit derivatives (whereas over 80% usedInterest Rate and FX derivatives).

At rst glance, the potential benets o credit derivatives or the cor-porate market seem compelling. Corporates are exposed to credit riskin several dierent ways, such as customer accounts receivable, vendor

Frequently portrayed

during the late 1990s and

early 2000s as the next

big thing in corporate

risk management, credit

derivatives were expectedto follow in the footsteps

of FX and interest rate

derivatives, and become

essential elements of the

corporate treasurers risk

management toolkit.


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nancing and counterparty exposure resulting rom other derivativetransactions. Tese exposures can be large (one study showed thator large European corporates, credit risk existed on over 20% o theirtotal balance sheet assets), and in many cases highly concentrated,as many companies have customers clustered in a relatively small

number o sectors and / or geographies. While there are a number oexisting credit risk management tools available other than credit de-rivatives (such as credit insurance, receivables actoring or securiti-zation, and surety bonds), these tools all have major shortcomingswhen compared to credit derivatives. Credit insurance, or example,requires proo o loss prior to any compensation payment (whichcredit derivatives do not), and the buyer tends to retain a portiono the risk (due to rst loss provisions), while credit derivatives en-sure a complete risk transer. Perhaps most importantly, providerso credit insurance oen have the right to revoke or reduce coverage

in the event o a credit downgrade, thus eliminating protection whenit may be most required, whereas credit derivatives do not carry thisrisk. Factoring and securitization can be an expensive method omanaging credit risk and are oen also subject to rst loss provi-sions, and may be seen more as sources o working capital nancingrather than risk management tools. Finally, all o these tools tend tobe restricted in terms o duration, and getting protection or longerthan one year can prove dicult, providing little protection againstlonger term exposures. As such, credit derivatives appear to be apotentially attractive and cost-eective credit risk management tool,without many o the drawbacks o the existing alternatives.

So, why has the credit derivative market remained an unappealingone or corporate risk managers? Perhaps the biggest impediment tothe use o credit derivatives by the corporate market is the basis riskcaused by an oen imperect relationship between the exposure andthe hedging instrument. As credit derivatives were initially designedto enable banks and nancial institutions to manage credit risk, it isperhaps unsurprising to nd that such basis risk exists, which re-fects a mismatch between the usual corporate credit exposure andthe parameters o a typical credit derivative. A common source o

such basis risk relates to the conditions which govern a credit de-rivatives pay-out (i.e. the credit event), and true credit exposureacing the corporate purchaser o the derivative. I the purchaser isa corporate hedging its receivables book, it is possible that a deaultwould take place on the receivables side without the occurrence othe specied credit event (e.g. bankruptcy, bond deault). Basis riskalso occurs due to timing mismatches (the most liquid CDS marketsare or durations o at least 5 years, ar longer than a typical receiv-able credit exposure). A second obstacle, related to this basis risk, isthe impact o credit derivatives on income statement volatility. Due

to mark to market requirements, credit derivatives can create signi-

While there are a num-

ber of existing credit risk

management tools avail-

able other than credit

derivatives (such as creditinsurance, receivables

factoring or securitization,

and surety bonds), these

tools all have major short-

comings when compared

to credit derivatives.


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cant P&L swings, without an o-setting P&L exposure.

Despite the increasing corporate ocus on credit risk managementin the wake o the nancial crisis, these key impediments to thedevelopment o a corporate market or credit derivatives are still

very much relevant. In addition, as the reputation o nancial de-rivatives in general (and credit derivatives in particular) was nothelped by unfattering media exposure during and aer the crisis,it seems unlikely that many corporates will decide that now is thetime to position themselves as pioneers in the use o credit deriva-tives or corporate credit risk management. Instead, it is perhapsmore likely that the tried and tested approaches to credit risk man-agement, such as rigorous credit analysis and monitoring, and themaintenance o strong relationships with key customers, will in-crease in priority and rise up the corporate agenda. Te role o the

corporate derivatives market as a risk indicator will undoubtedlygrow, however, as more and more corporates look to enhance theircredit monitoring capabilities and prevent an over-reliance on 3rdparty credit ratings. Many corporate treasuries have already begunto implement internal credit and counterparty risk monitoringdashboards which incorporate various market indicators, includ-ing credit derivative market data such as CDS spreads.

One area o corporate nancial risk management which may oermore potential or the uture o credit derivatives relates to theiruse by corporates to acilitate access to uture unding sources, and/ or to manage existing liabilities. Such applications had alreadybegun to show some promise beore the onset o the crisis, withcorporates beginning to use credit derivatives to ree up creditlines and protect themselves against uture increases in the costo unding. As the issue o corporate liquidity risk has risen inprole along with credit risk ollowing the nancial crisis, it is verypossible that corporate treasurers will revisit the credit derivativesmarket in the months ahead, as a means to ensure access to aord-able unding sources in a period where lenders remain cautiousand the risk o material uture increases in unding costs remains

high. Such strategies can involve corporates taking positions intheir own credit derivatives, and either buying protection to hedgeagainst uture increases in unding costs or even selling credit pro-tection to lower current unding costs should the company believetheir current credit spread is unnecessarily high (an undoubtedlyaggressive strategy).

As the credit derivatives market continues to evolve, and as corpo-rate treasurers look or new and more eective approaches to man-aging credit risk, it is increasingly likely that greater corporate ap-

As the issue of corporate

liquidity risk has risen in

profile along with credit risk

following the financial crisis,

it is very possible that corpo-

rate treasurers will revisit the

credit derivatives market in

the months ahead, as a means

to ensure access to affordable

funding sources in a period

where lenders remain cautious

and the risk of material future

increases in funding costs

remains high.


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Kevin Lester

Director of Risk Management and

Treasury Services

Kevin is Director o Risk Management &reasury Services at Validus Risk Manage-ment and Contributing Editor or Risk atgtnews.com. Previously Head o Risk Man-agement or Europe, the Middle East andArica (FX and Commodities) at Alcan(now Rio into), Kevin has several yearso corporate treasury experience with Dow

Chemical and Avery Dennison. He is amember o the Proessional Risk ManagersInternational Association (PRMIA).

Validus Risk Management ocus on help-ing clients to design and implement robuststrategies and processes to measure, moni-tor and manage nancial risk. Our mainservices include:

Foreign Exchange Risk Management Interest Rate Risk Management Commodity Price Risk Management

Te Validus team has decades o experiencein the eld o nancial risk managementand has worked successully with leadingmultinational corporations and nancialinstitutions around the world.

A Structured Approach to Financial Risk Management

plications or instruments like CDSs as creditrisk management tools will be ound. How-ever, although the nancial crisis has height-ened awareness and concern about corporatecredit risk, the drawbacks o the corporate us-

age o credit derivatives have not gone away,and the likelihood o a sudden growth in themarket or credit derivatives as a solution orcorporate credit risk management appearsremote. Despite this, the increasing impor-tance o the credit derivatives market or thecorporate treasurer should not be discounted.At the very least, it will continue to providetreasurers with timely and market-drivencredit indicators or both customers and -

nancial counterparties, and credit derivativescould even acilitate the implementation oinnovative approaches or managing liquidityrisk and unding costs. In an era where bothcredit risk and liquidity risk remain high onthe corporate treasurers agenda, a marketwhich oers potential solutions or the man-agement o both o these risks must be care-ully considered.

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Credit Derivatives White Paper