It has been popular to blame derivatives for being a driver of the current financial crisis. What has in fact been their role?
Derivatives remain integral to the world financial system, and indeed almost 95 per cent. of the world's largest companies continue to use derivatives (even some of Warren Buffet's companies). At the end of 2008, the notional amount of CDS contracts was $38 trillion; of equity derivatives $8.7 trillion; and of interest rate derivatives $403.1 trillion. The derivatives which caused problems though, were actually (by notional amount) a tiny part of the overall market; for example - credit default swaps referencing toxic mortgage backed securities did not account for even 0.5 per cent. of the credit derivatives market and only a handful of CPDOs were ever done.
Other things which contributed to the finger-pointing included a lack of understanding of the different derivatives products and how they work, leading to some tarring all derivatives with the same brush; and some products such as securities backed by sub-prime mortgages, being labelled as credit derivatives, when they are not.
Has the market in derivatives changed since the crisis and how has the current situation affected legal advisers and their work load?
There have certainly been some changes. For example, credit defaults swaps referencing asset-backed securities are now done to mitigate the effect of holding toxic assets on the balance sheet, rather than as negative basis trades. Synthetic CDOs and similar structured products are now a rarity. However, credit derivatives referencing portfolios of loans on a bank's balance sheet are now popular for regulatory capital reasons. Equity derivatives being used for financings and interest rate swaps embedded in bank loans are more popular than ever.
A greater premium is being placed on legal advisers with a deep understanding of the products. There has also been an increase in derivatives disputes and institutions carrying out audits of their derivatives porfolios, all of which involve heavy involvement from legal advisers.
What, in a nutshell, are credit derivatives?
Derivatives are financial instruments (such as swaps, option and bonds) which derive their value from an underlying asset. In the case of credit derivatives, this is the underlying asset of the creditworthiness of a corporate or sovereign referenced in the financial instrument. One party to a transaction will purchase credit protection and the other (perhaps a swap counterparty or bondholder) will sell credit protection against credit events occurring such as the referenced company filing for bankruptcy or defaulting under its bond.
In some ways credit derivatives are similar to insurance, however there are some distinguishing features such as the purchaser of protection not having to hold any debt of the referenced company. If a credit event occurs the credit protection seller will compensate the buyer for the decline in the value of the defaulting company's debt. If no credit event occurs during the transaction's term then the credit protection seller will have had the benefit of receiving a premium; rather like an insurer who has not had to make any payments under a policy.
A single credit derivative can reference one corporate or sovereign or many more; and the variations and additional complexities can be vast.
How can credit derivatives help?
Credit derivatives allow credit risk to be traded as a separate asset class. A bond for example also contains other risks such as interest rate risk and even currency and market risk. They assist in freeing up capital for banks to lend as they can remove credit risk concentrations on a bank's balance sheet and free up regulatory capital. Credit derivatives allow for the dispersion of credit risk (which although has its critics, means that the bankruptcy of a single company is less likely to impact as significantly on that company's lenders as it would otherwise do). They also allow for parties to diversify their credit risks or to gain exposure to debt issuers in different jurisdictions or sector.
If I hold derivatives or structured products in my portfolio, what should I be worried about?
Your biggest concern should be that you understand what you have. Do you understand how the product works? Are you aware of the risks involved? Have you got sufficient hedging in place? Should you be looking at the diversity of products and risk concentrations.
That said many of the losses I have seen in derivatives have been through parties tripping up on the basics. When Lehman defaulted I received many calls from counterparties of Lehman that had never put an ISDA Master Agreement or credit support annex in place - leaving them very exposed.
Some later discovered that they had sent through event of default notices under an ISDA Master Agreement by fax - something not permitted under the agreement's terms, meaning that losses were not closed-out until the error discovered. In some cases, due to mark to market movements, the losses may prove considerable.
With that in mind I would advise any derivatives user to make sure that they have a robust infrastructure in place for dealing with distressed situations. The chapter on managing a major credit event in my credit derivatives book is an example of how to do this for credit derivatives, and has indeed been adopted by several investment banks as their global strategy for dealing with major credit events.