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Credit Derivatives Market Innovation - Reframing the issue

Whether the market can rethink its approach to the complexity of credit derivatives is discussed by Brad Bailey, director in business development at Knight Capital Group

Since the sub-prime summer of 2007, the credit market has posed a number of challenges. The impact has been powerful and the ramifications are very much being felt. The street is littered with the heads of the fallen, from junior analysts to bulge-bracket ceos.

It is often said that, while success has many parents, failure is an orphan - which is not the case when it comes to dissecting the causes of the credit crisis. There are myriad explanations: all the readers of SCI will have their own theories.

The pain has been real for investors. But, from the pain, can some good come of it?

Despite the valiant efforts of many market participants, despite regulatory pressure in the past to clean up operational challenges in various OTC markets, there still has not been enough action to change certain practices in the industry. An entire industry has been born on top of products that have grown beyond their ability to function with the level of demands on them.

As creative as they are, many solutions offered to the OTC derivative world are solving just part of the problem. Perhaps the fundamental issue has to be restated.

The success, on-going growth and adoption of credit derivatives result from the fact that they solve a very big problem. Just as their predecessors offered a means of mitigating such risks as interest rate or exchange rate risk, they have offered an effective means of mitigating credit risk.

They have grown bigger and faster than most could imagine. It makes perfect sense, as mitigating credit risk is hugely important.

It is, hence, logical that the credit derivative is considered to be one of the most important financial innovations of recent times. But what if the solution becomes the problem?

The credit derivative market has evolved in a piecemeal fashion. Challenges arise and solutions are offered reactively, reflecting the best possibility for a given time. Dedicated professionals have come together time and again, despite high levels of competition with one another, to solve each new problem: definitions, events, settlements, lock-ins and so on.

After 15 years of this iterative process, we have wonderful parts but a whole that does not add up. An optimist thinks we live in the best of all possible worlds, a pessimist knows it. The credit derivative as a tool for mitigation of risk and for creating innovative products has been a huge success; the credit derivative as a product gets a less than glowing review.

In other words, perhaps we have not been framing the problem correctly to date. We need what a credit derivative can do, but the vessel to affect that is so imperfect that it has created numerous problems.

Ultimately, the mid-to-long term impact of the credit market dislocation is not clear. What is clear, however, is that the ability to offer credit risk mitigation is a huge benefit to many.
There is nothing like a market meltdown to help people rethink their approach to the complexity of this market. From a transparency, valuation, accounting, trading, settlement and operational perspective, there is a lot of work to be done.

[full article]

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