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Trading and Capital-Markets Activities Manual

Instrument Profiles: Credit Derivatives  (Continued)
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

HEDGING 

Credit derivatives may be hedged in two basic ways: users may match (or offset) their credit-derivative contracts, or they may use a cash position in the reference asset to hedge their contracts. 

The ideal hedging strategy for dealers is to match positions, or to conduct ''back-to-back'' trading. Many deals actually are backed to back with offsetting transactions as a result of the highly structured nature of deals. That is, dealer banks won't enter into a credit-derivative trade unless a counterparty willing to enter the offsetting transaction has been identified. Alternatively, the credit-derivative-trading function may back to back trades with an internal counterparty (for example, the bank's own loan book). Because the secondary-market support for credit derivatives is characterized by substantial illiquidity, credit positions which are taken through credit derivatives may be ''warehoused'' for substantial periods of time before an offsetting trade can be found. Banks often set trading limits on the amount and time period over which they will warehouse reference-asset credit exposures in credit-derivative transactions. 

The second basic hedging practice is to own the underlying reference asset. Essentially, the risk-selling bank hedges by going long the reference asset and going short the swap. This is the simplest form of matched trading and is illustrated by Bank A in figures 1 and 2. Generally, whether or not the bank owned the reference asset before it entered the swap is a good indication of the purpose of the swap. If the bank owned the asset before executing the swap, it has most likely entered the swap for risk-management reasons. If the bank acquired the asset for purposes of transacting the swap, it is more likely to be accommodating a customer. 

Interestingly, hedging a credit derivative in the cash market is not common when the cash position required is a short. Generally speaking, going short the reference asset and long the swap is problematic. To show this, consider what happens in a declining market: The long credit-derivative position (total-return receiver) declines in value, while the short cash position rises in value as the market falls. Unfortunately, most lenders of a security which is falling in value will not agree to continually lend and receive back a security that is undergoing a sustained depreciation in value. Since most short sales are very short term (in fact, overnight), the short cash hedge becomes unavailable when needed most-when there is a prolonged decline in the value of the reference asset. For this reason, a short credit-derivative position may be superior to a short cash position that must be rolled over. 

A third and less common practice is to simply add or subtract the notional amount of long or short positions, respectively, to or from established credit lines to reference obligors. This is the least sophisticated risk-management treatment and is inadequate for trading institutions as it does not address counterparty risks. This method may be used effectively in conjunction with other methods and is useful in determining total potential credit exposure to reference obligors. 

At some point, the potential exists for credit-derivatives dealers to apply a portfolio risk-management model that recognizes diversification and allows hedging of residual portfolio risks. However, the fundamental groundwork for quantitative modeling approaches to credit derivatives is still in development. 

Finally, two other hedging issues are worth considering. First, it is not uncommon for banks to hedge a balance-sheet asset with a credit derivative that references a different asset of the same obligor. For example, a bank may hedge a loan to ABC Company that is highly illiquid with a credit-default swap that references the publicly traded debt of ABC Company. The fact that the public debt is more liquid and has public pricing sources available makes it a better reference asset than the loan. However, the bank is exposed to the difference in the recovery values of the loan and the debt if ABC Company defaults. Second, it is very common for the term of the credit derivative to be less than the term of the reference asset. For example, a two-year credit default swap could be written on a five-year bond. In this case, the last three years of credit risk on the underlying bond position would not be hedged. The appropriate supervisory treatment for credit derivatives is provided in SR-96-17 (see section 3020.1, ''Securitization and Secondary-Market Credit Activities''). 

RISKS 

Credit Risk 

Banks using credit derivatives are exposed to two sources of credit risk: counterparty credit risk and reference-asset credit risk. In general, the most significant risk faced by banks in credit derivatives will be their credit exposure to the reference asset. 

When a bank acquires credit exposure through a credit-derivative transaction, it will be exposed primarily to the credit risk of the reference asset. As with credit risk that is acquired through direct purchase of assets, banks should perform sufficient credit analysis of all reference assets to which they will be exposed through credit-derivative transactions. The financial analysis performed should be similar to that done for processing a loan or providing a letter of credit. Further, banks should have procedures in place to limit their overall exposure to certain borrowers, industries, or geographic regions, regardless of whether exposures are taken through cash instruments or credit-derivative transactions. 

Examiners should be aware that the degree of reference-asset credit risk transferred in credit-derivative transactions varies significantly. For example, some credit derivatives are structured so that a payout only occurs when a predefined event of default or a downgrade below a pre-specified credit rating occurs. Other credit derivatives may require a payment only when a defined default event occurs and a predetermined materiality (or loss) threshold is exceeded. Default payments may be based on an average of dealer prices for the reference asset during some period of time after default using a pre-specified sampling procedure or may be specified in advance as a set percentage of the notional amount of the reference asset. Lastly, the terms of many credit-derivative transactions are shorter than the maturity of the underlying asset and, therefore, provide only temporary credit protection to the beneficiary. In these cases, some of the credit risk of the reference asset is likely to remain with the asset holder (protection buyer). 

Alternatively, a bank may own an asset whose risk is passed on to a credit-derivative counterparty. As such, the bank will only lose money if the asset deteriorates and the counterparty is unable to fulfill its obligations. Therefore, banks using credit derivatives to reduce credit exposure will be exposed primarily to counterparty risk. Because the ultimate probability of a loss for the bank is related to the default of both the reference credit and the inability of a counterparty to meet its contractual obligations, banks should seek counterparties whose financial condition and credit standing are not closely correlated with those of the reference credit. 

In all credit-derivative transactions, banks should assess the financial strength of their counterparty before entering into a credit-derivative transaction. Further, the financial strength of the counterparty should be monitored throughout the life of the contract. In some cases, banks may deem it appropriate to require collateral from certain counterparties or for specific types of credit-derivative transactions. 

Market Risk 

While banks face significant credit exposure through credit-derivative transactions, significant market risk is also present. The prices of credit-derivative transactions will fluctuate with changes in the level of interest rates, the shape of the yield curve, and credit spreads. Furthermore, because of the illiquidity in the market, credit derivatives may not trade at theoretical prices suggested by asset-swap pricing methodologies. Therefore, price risk is a function of market rates as well as prevailing supply and demand conditions in the credit-derivative market. 

The relative newness of the market for credit derivatives and the focus of some products on events of default makes it difficult for banks to hedge these contingent exposures. For example, banks that sell default swaps will probably make payments quite infrequently because events of default are rare. Hence, the payoff profile for a default swap includes a large probability that default will not occur and a small probability that a default will occur with unknown consequences. This small probability of a default event is difficult for banks to hedge, especially as the reference asset deteriorates in financial condition. 

Liquidity Risk 

Typically, liquidity risk is measured by the size of the bid/ask spread. Similar to other new products, credit derivatives may have higher bid/ask spreads because transaction liquidity is somewhat limited. Banks buying credit derivatives should know that their shallow market depth could make it hard to offset positions before a credit derivative's contract expires. Accordingly, banks selling credit derivatives must evaluate the liquidity risks of credit derivatives and assess whether some form of reserves, such as close-out reserves, is needed. 

Banks using credit derivatives should include the cash-flow impact of credit derivatives into their regular liquidity planning and monitoring systems. Banks should also include all significant sources and uses of cash and collateral related to their credit-derivative activity into their cash-flow projections. Lastly, the contingency funding plans of banks should assess the effect of any early termination agreements or collateral/margin arrangements, along with any particular issues related to specific credit-derivative transactions. 

Legal Risk 

Because credit derivatives are new products that have not yet been tested from a legal point of view, many questions remain unanswered. At a minimum, banks should ensure that they and their counterparties have the legal and regulatory authority to participate in credit-derivative transactions before committing to any contractual obligations. Moreover, banks should ensure that any transactions they enter into are in agreement with all relevant laws governing their activities. 

While standard documentation for credit derivatives has yet to be developed, participating banks should use standardized documentation as soon as it becomes available. ISDA has been developing a standardized master agreement for use with credit-derivative transactions. Banks should have their legal counsel review all credit-derivative contracts to confirm that they are legally sound and that all terms, conditions, and contingencies are clearly addressed. 

Examiner Guidance 

When reviewing credit derivatives, examiners should consider the credit risk of the reference asset as the primary risk. A bank providing credit protection through a credit derivative can become as exposed to the credit risk of the reference asset as it would if the asset were on its own balance sheet. Thus, for supervisory purposes, the exposure typically should be treated as if it were a letter of credit or other off-balance-sheet guarantee. For example, this treatment would apply when determining an institution's overall credit exposure to a borrower when evaluating concentrations of credit. 

In addition, examiners should perform the following procedures. 

  Review SR-96-17. 
  Note the bank's credit-derivative activities and ascertain (1) the level of credit-derivative activity, (2) the types of counterparties, (3) the typical underlying reference assets, (4) the structures and maturities of the transactions, (5) why management is using these instruments, and (6) whether the bank's credit exposure is being increased or reduced. 
  Evaluate whether the bank subjects its credit-derivatives activities to a thorough, multifunctional new-product review and determine if senior management is aware of and approves the activities undertaken. 
  Ensure that credit derivatives are reported correctly for regulatory purposes based on amendments to the call report and the FRY-9C as of March 31, 1997. Examiners should determine that any transfer risk received or passed on in a credit-derivative structure is captured in the bank's regulatory transfer risk reports.   Ensure that the bank maintains documentation for its accounting policies for credit derivatives; examiners should determine whether the bank has consulted with outside accountants when determining its accounting policies and procedures for credit derivatives. Additionally, examiners should assess the bank's markto-market, profit recognition, and hedge-accounting practices. 
  Review management's strategy for using credit derivatives, assessing the impact on the bank's risk profile and ensuring that adequate internal controls have been established for the conduct of all trading and end-user activities in credit derivatives. 
  Review risk-management practices to ensure that bank systems capture and trading desks report all credit exposures to senior management, including counterparty and reference-asset exposures from credit derivatives. 
  Ensure that risk-management reports are done on a timely basis and are disseminated to the appropriate personnel. 
  Assess the bank's treatment of credit derivatives for purposes of legal lending limits, that is, when should the bank use credit derivatives to lower borrower concentrations and which type of credit derivative should the bank use. Further, examiners should ensure that the bank is in compliance with all regulatory lending limits. 
  Review the bank's asset quality and loan-loss reserve policies with respect to credit derivatives and any reference assets owned. Examiners should ensure that assets protected by credit derivatives that are nonperforming are recognized in internal credit reports and assess how the bank's loan-loss reserves are affected by the use of credit derivatives. Moreover, examiners should ensure that the bank's classification system is reasonable given the types of credit-derivatives structures used, the degree to which credit risk is transferred, and the creditworthiness of its credit-derivative counterparties. 
  Procure and review relevant marketing materials and policies regarding sales practices. Dealers should assess the financial character and sophistication of all counterparties. Since credit derivatives are new and complex instruments, dealers should provide end-users with information sufficient to understand the risks associated with particular credit-derivative structures. 

ACCOUNTING TREATMENT 

The accounting treatment for certain credit derivatives is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

The appropriate risk-based capital treatment for credit-derivative transactions is included in SR-96-17. The appropriate treatment for credit derivatives under the market-risk capital amendment to the BIS Accord is not finalized as of this writing. As a general rule, SR-96-17 provides the appropriate capital treatment for credit derivatives which are carried in the banking book and for institutions which are not subject to the market-risk rules. 

Under SR-96-17, credit derivatives generally are to be treated as off-balance-sheet direct credit substitutes. The notional amount of the contract should be converted at 100 percent to determine the credit-equivalent amount to be included in risk-weighted assets of the guarantor. 2 A banking organization providing a guarantee through a credit-derivative transaction should assign its credit exposure to the risk category appropriate to the obligor of the reference asset or any collateral. On the other hand, a banking organization that owns the reference asset upon which credit protection has been acquired through a credit derivative may, under certain circumstances, assign the unamortized portion of the reference asset to the risk category appropriate to the guarantor, for example, the 20 percent risk category if the guarantor is a bank, or the 100 percent risk category if the guarantor is a bank holding company. 

Whether the credit derivative is considered an eligible guarantee for purposes of risk-based capital depends on the degree of credit protection actually provided. As explained earlier, the amount of credit protection actually provided by a credit derivative may be limited depending on the terms of the arrangement. For example, a relatively restrictive definition of a default event or a materiality threshold that requires a comparably high percentage of loss to occur before the guarantor is obliged to pay could effectively limit the amount of credit risk actually transferred in the transaction. If the terms of the credit-derivative arrangement significantly limit the degree of risk transference, then the beneficiary bank cannot reduce the risk weight of the ''protected'' asset to that of the guarantor bank. On the other hand, even if the transfer of credit risk is limited, a banking organization providing limited credit protection through a credit derivative should hold appropriate capital against the reference exposure while it is exposed to the credit risk of the reference asset. See section 3020.1, ''Securitization and Secondary-Market Credit Activities.'' 

Banking organizations providing a guarantee through a credit derivative may mitigate the credit risk associated with the transaction by entering into an offsetting credit derivative with another counterparty, a so-called ''back-to-back'' position. Organizations that have entered into such a position may treat the first credit derivative as guaranteed by the offsetting transaction for risk-based capital purposes. Accordingly, the notional amount of the first credit derivative may be assigned to the risk category appropriate to the counterparty providing credit protection through the offsetting credit-derivative arrangement (for example, to the 20 percent risk category if the counterparty is an OECD bank). 

In some instances, the reference asset in the credit-derivative transaction may not be identical to the underlying asset for which the beneficiary has acquired credit protection. For example, a credit derivative used to offset the credit exposure of a loan to a corporate customer may use a publicly traded corporate bond of the customer as the reference asset, whose credit quality serves as a proxy for the on-balance-sheet loan. In such a case, the underlying asset will still generally be considered guaranteed for capital purposes as long as both the underlying asset and the reference asset are obligations of the same legal entity and have the same level of seniority in bankruptcy. In addition, banking organizations offsetting credit exposure in this manner would be obligated to demonstrate to examiners that (1) there is a high degree of correlation between the two instruments; (2) the reference instrument is a reasonable and sufficiently liquid proxy for the underlying asset so that the instruments can be reasonably expected to behave similarly in the event of default; and (3) at a minimum, the reference asset and underlying asset are subject to mutual cross-default provisions. A banking organization that uses a credit derivative, which is based on a reference asset that differs from the protected underlying asset, must document the credit derivative being used to offset credit risk and must link it directly to the asset or assets whose credit risk the transaction is designed to offset. The documentation and the effectiveness of the credit-derivative transaction are subject to examiner review. Banking organizations providing credit protection through such arrangements must hold capital against the risk exposures that are assumed. 

2. Guarantor banks which have made cash payments representing depreciation on reference assets may deduct such payments from the notional amount when computing credit-equivalent amounts for capital purposes. For example, if a guarantor bank makes a depreciation payment of $10 on a $100 notional total-rate-of-return swap, the credit-equivalent amount would be $90. 

LEGAL LIMITATIONS FOR BANK INVESTMENT 

While examiners have not seen credit-derivative transactions involving two or more legal entities within the same banking organization, the possibility of such transactions exists. Transactions between or involving affiliates raise important supervisory issues, especially whether such arrangements are effective guarantees of affiliate obligations, or transfers of assets and their related credit exposure between affiliates. Therefore, banking organizations should consider carefully the existing supervisory guidance on inter-affiliate transactions before entering into credit-derivative arrangements involving affiliates, especially when substantially the same objectives could be achieved using traditional guarantee instruments. 

Legal lending limits are established by individual states for state-chartered banks and by the Office of the Comptroller of the Currency (OCC) for national banks. Therefore, the determination of whether credit derivatives are guarantees to be included in the legal lending limits are the purview of the state banking regulators and the OCC. 

REFERENCE 

Board of Governors of the Federal Reserve System. SR-96-17, ''Supervisory Guidance for Credit Derivatives.'' August 12, 1996. 4350.1 Credit Derivatives

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