Size of the credit derivatives market and impediments to growth

The first credit derivative transactions occurred in the early 1990s, as large derivative
dealers searched for ways to transfer risk exposures on financial derivatives. Their
objective was to be able to increase derivatives business with their largest counterparties.
The market grew slowly at first. More recently, growth has accelerated as
banks have begun to use credit derivatives to make portfolio adjustments and to
reduce risk-based capital requirements.
As discussed in greater detail below, there are four credit derivative products:
credit default swaps (CDS), total return swaps (TRS), credit-linked notes (CLNs) and
credit spread options. Default swaps, total return swaps and credit spread options are
over-the-counter transactions, while credit-linked notes are cash market securities.
Market participants estimate the current global market for credit derivatives will
reach $740 billion by the year 2000.2 Bank supervisors in the USA began collecting
credit derivative information in Call Reports as of 31 March 1997. Table 11.1 tracks
the quarterly growth in credit derivatives for both insured US banks, and all institutions
filing Call Reports (which includes uninsured US offices of foreign branches).
The table’s data reflect substantial growth in credit derivatives. Over the two years
US bank supervisors have collected the data, the compounded annual growth rate of
notional credit derivatives for US insured banks, and all reporting entities (including
foreign branches and agencies), were 216.2% and 137.2% respectively.
Call Report data understates the size of the credit derivatives market. First, it
includes only transactions for banks domiciled in the USA. It does not include the
activities of banks domiciled outside the USA, or any non-commercial banks, such
as investment firms. Second, the data includes activity only for off-balance sheet
transactions; therefore, it completely excludes CLNs.

Activity in credit derivatives has grown rapidly over the past two years. Nevertheless,
the number of institutions participating in the market remains small. Like
financial derivatives, credit derivatives activity in the US banking system is concentrated
in a small group of dealers and end-users. As of 31 March 1999, only 24
insured banking institutions, and 38 uninsured US offices (branches and agencies)
of foreign banks reported credit derivatives contracts outstanding. Factors that
account for the narrow institutional participation include:
1 Difficulty of measuring credit risk
2 Application of risk-based capital rules
3 Credit risk complacency and hedging costs
4 Limited ability to hedge illiquid exposures and
5 Legal and cultural issues.
An evaluation of these factors helps to set the stage for a discussion of credit
derivative products and risk management issues, which are addressed in subsequent
sections.