Banks turning to credit derivatives as trading tools

By Gillian Tett
Financial Times, London
Thursday, May 24, 2007

http://www.ft.com/cms/s/0cc43410-0a26-11dc-93ae-000b5df10621.html

Global banks have started to use credit derivatives to expand their level of risk-taking -- rather than to hedge their own credit risks, according to new analysis.

In particular, large global banks, as a sector, are now writing growing numbers of contracts that sell credit risk protection to other counterparties -- instead of buying protection for their own lending risks, internal analysis from Fitch rating agency suggests.

The analysis challenges the widely held assumption that the expansion of the credit derivatives sector has helped banks, as a whole, to shed risk from their own books. Consequently, the pattern may provoke a new debate about the wider impact of the way that risk is being transferred between different players in the financial system, as innovation gathers pace.

The Fitch analysis of banks' net positions with credit derivatives was partly drawn up by its financial industry team, using bank data and other sources.

It suggests that during the period from 2002 to 2005, banks, as a sector, were using credit derivatives to reduce their exposure to risk by "buying" more protection from other counterparties, via credit default swap contracts, than they were "selling."

These contracts typically work by one counterparty agreeing to "sell" protection to another -- meaning that the "protected" party pays a fee each year in exchange for a guarantee that if a bond goes into default, the seller of protection will provide compensation.

However, last year the banking sector as a whole became a net "seller" of credit protection, according to Fitch calculations -- meaning that banks wrote more contracts to sell protection to other counterparties than they bought.

The other parties who have been selling exposure on a large scale are believed to be insurance companies and specialist credit derivative product companies. Those buying protection are believed to include hedge funds and pension groups.

A key reason for this switch, Fitch believes, is that banks are now placing more importance on credit derivatives as trading tools, not hedging instruments: whereas 30 percent of banks it recently surveyed suggested that hedging was a "dominant" motive for using CDS, 43 percent used it for intermediary purposes, and 51 percent used it for trading. This pattern has helped to drive a dramatic expansion in trading volumes in the CDs world in the last year.

However it has also dramatically boosted overall use of CDs: the total size of the sector has grown from less than $1,000 billion at the start of the decade to more than $33,000 billion at the end of last year, with most of the expansion having occurred in the last three years.

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