Too many wrong assumptions are being made about risk exposure via credit derivatives, argues Robert Pickel, chief executive of the International Swaps and Derivatives Association, in Tuesday’s Insight column.
There has been a significant overstatement of the net settlement flows that would result on default of “underlying” entities. Added to the already severe market volatility these assumptions may wrongly contribute towards a dangerous climate of fear in financial markets, suggests Pickel. In particular, offsetting positions are being ignored.
A recent Fitch Ratings survey estimates net exposure at less than $1,000bn. Factor in a probability of default of 2 per cent and a 25 per cent recovery rate and protection sellers would have to settle an aggregate $15bn of losses. None of these amounts would be “lost” to the system; a credit derivative simply transfers a potential gain/loss from one party to another. Clearly, while $15bn is not trivial, it is a small fraction of aggregate write-offs to date on loans and securities; and less than a 10th of Mr William Gross’s (Pimco chief) $50,000bn suggestion which actually references the “underlying” bonds and loans being protected by use of credit derivatives.
And our figures are conservative: we use a slightly higher ($50,000bn) figure for the total reference amounts; we round up the net exposure figure; we use a higher default rate than the 1.25 per cent used elsewhere; and our projected recovery rate is much lower than the 50 per cent used by Mr Gross.
Strip out the conservatism we build in here and those overstatements look extreme. While variations in each of these factors will have some impact on the final numbers, these are clearly most sensitive to the distinction between the aggregate reference amount of $50,000bn and that for net risk transfer of $1,000bn. Meanwhile, industry and regulators remain focused on refinements to the critical discipline of counterparty credit risk management. Netting and collateral are important mitigants here, reducing so-called “presettlement” market exposures substantially.
It is appropriate that a debate occur and that lessons be learnt from the way credit markets function. But we should recognise that privately negotiated credit derivatives markets have not only played a key role in allowing prudent and dynamic hedging of credit risk but have stayed open for business in spite of reduced liquidity in securities and interbank deposit markets.
The main point, however, remains a more basic one. Gross numbers are no basis on which to estimate the impact of the market in credit derivatives; net exposure is the place to start.
