Credit, Leverage and Transparency - A Common Thread?

Traders move on and markets forget. Venerable truisms are especially applicable in derivatives trading. But it seems this time, institutions have absorbed some of the lessons of the Asia crisis for the long term. Whether they have really done so will be borne out by the behaviour of the market in future times of stress.

At the start of 1998, the markets were still in the throes of the Asian crisis, which had blindsided market participants and then kept them guessing as to what would be the knock-on effects. Then came the volatility of autumn 1998, the debate about the role of hedge funds, leverage and regulation.

Last year saw Asian markets come surging back, leaving us with credit spreads now at three-year lows and Asian equity markets being strongly bought. These events have precipitated changes in the environment in which interest rate derivatives are traded and as a result a number of clear trends are being established for the future.

Credit

An important result of the debacle of the Asian crisis is the increased desire of banks and liquidity providers to consider more precisely the value of possible credit liability when entering into derivative contracts. Before this period, the dynamic nature of the credit risk associated with derivative contracts was not a focus for the trading desks of many institutions.

However, when viewed in the most general sense, even the simplest interest rate swap is really a two-parameter credit derivative. This follows from the fact that although the initial mark-to-market of the trade will be close to zero, there are future states of the world in which the counter party becomes insolvent after the market has moved in such a way that the counter party owes money on the trade.

The credit exposure in such cases is not constant, but is functionally linked to the market risk of the underlying contract. This makes such credit exposure difficult to manage, even if the ability exists to put a fair price on such an exposure ab initio. As an example, suppose a BBB rated corporate needs to do a four-year currency swap on USD/baht, where the USD/baht foreign exchange volatility is assumed to be 10% until the maturity of the trade. If the corporate's four-year eurobonds trade at USD libor +100 basis points, and assuming the likelihood of default is not correlated with movements in the currency pair, then the cost of this credit risk may be valued at around 7bp per annum.

If the default risk is positively correlated to the market risk then this cost will be larger; if negatively correlated, smaller.

Although market pricing still can be inconsistent in respect of credit - some trades still go through at a level that seems tight when viewed on the basis of rationally priced contingent credit exposure - liquidity providers do now generally price in an appropriate credit premium. Clearly, if the market sensitivity of the risk to be assumed offsets existing positions with that particular counter party, then the appropriate charge should be a different, lower, value. In all cases the pricing, though it can be worked out, is not simple.

Hedging is an even bigger problem. It is possible to imagine trades structured especially to hedge such contingent credit risk; for example, an option on a currency swap that only pays out if a given counter party goes into default during the life of the swap. However, the market in such trades is currently highly illiquid and cannot be relied on to provide hedges for even a small portion of the business a house might want to do. Agreements to terminate swaps for cash on a credit downgrade or simply at the option of either party also are desirable in mitigating credit exposure, but again are not always applicable and do not entirely negate the risk.

An alternative to charging counter parties more for a given swap are agreements to mutually collateralise trades up to the mark-to-market value. It is also possible to take "haircuts" above this level to accommodate market fluctuation in between collateral top ups. But some credit risk linked to the volatility of the market still remains.

Leverage

Leverage has played a key role in virtually every financial crisis this century (and in plenty more crises beforehand, too). Whether expressed as the ability of an entity to borrow more than the value of its capital base, or as the ability to take on profit and loss sensitivity to market, leverage has been the catalyst for some of the most serious market disruptions in recent history.

The turmoil of 1997 was greatly exacerbated by large "carry trade" positions in the market whereby participants borrowed US dollars and lent regional currencies, which were pegged or banded at artificial levels dictated by the authorities, yet yielded interest at a large premium to dollars. The chosen vehicles were currency swaps and the result was a form of disguised leveraged borrowing.

In 1998 the role of leverage was even more explicit, some hedge funds running positions which far outstripped their capital base. The true level of credit risk may be viewed, therefore, also as a function of what risk positions the counter party has on with other market practitioners.

In the case of the hedge fund crisis, very often the counter party, the collateral, the market risk and the erosion of market liquidity became correlated at close to unity, because of the size, lack of transparency and the nature of the positions involved.

With the benefit of hindsight, included in the price should have been i) knowledge of existing counter party positions, ii) liquidity information, iii) credit risk; and  iv) correlation of credit risk to market parameters.

Transparency

Thus, information about the nature of counter party's existing positions affects the price at which a trade should be done and indeed the ability to trade at all. Often this information is not available, as illustrated by the leveraged fund problems of 1998.

Currently, regulators worldwide are in the process of introducing standards whereby a wider range of entities will be forced to mark off balance sheet trades to market and be more explicit about the nature of positions they carry. The debate surrounding this issue is fierce but in light of the experience of 1997 and 1998 these steps should in principal be viewed as positive developments for the market.

Serious problems will occur, however, if regulation is implemented in such a way as to improperly recognize offsetting and hedged positions. This could have the result of falsely increasing the volatility and apparent risk sensitivity of an entity's position, which is not desirable. In this case, while the intention of the authorities was to increase the transparency of the market, poor implementation actually results in the reverse.

Conclusion

The more rigorous focus on derivative credit risk has led to improvements in pricing, systems and collateral management on the part of liquidity providers. The desire for greater market transparency is almost universal both with regulators and market players. In part because of these trends, Asia can look forward to a period of sustained growth in the interest rate derivative markets.

Increasing corporate issuance in G7 currencies to finance new investments will see further growth in the currency swap business. In addition, issuance in liquid regionals, notably Singapore dollar, will see growth in the regional currencies' nascent interest rate swap markets. Regionally, the business will become focused on locales that can provide the most transparency and liquidity with the minimum of regulation.

Recent history has shown us that credit risk, information flow and leverage are not separate considerations but in fact are very closely linked. Lack of market transparency increases the risk of inappropriate allocation of risk and resources. The best way to ensure that capital flows are rational is not to regulate them but rather to encourage such a high degree of transparency on the balance sheet and liquidity in the market that they regulate themselves.

With credit spreads tight, temptation will once again come to "gear up" positions, as traders attempt to make budgets set on the basis of the bull credit market of the last year. It is important for the region that the credit culture and systems of the participants and the level of transparency of the market continue to progress. Because, as the philosopher George Santayana said in 1906, towards the end of another period of relative global calm and prosperity: "Those who cannot remember the past are condemned to repeat it."