Debt Risk Shifting to Investors as Bank Regulations Bite

Vilified for worsening the financial crisis, the credit derivatives market is undergoing a structural shift as money managers take on risk shunned by banks after regulators forced lenders to shrink their dealings.

Investors now account for more than 25 percent of the $19.9 trillion market, up from 20 percent a year ago, according to the Depository Trust & Clearing Corp. They issued a net $132 billion of contracts insuring against losses on bonds as of June 6, the data show. This time last year they were net buyers of $15 billion of insurance.

While rules introduced after the collapse of Lehman Brothers Holdings Inc. to limit systemic risk have succeeded in cutting bank exposure to the opaque derivatives market, they haven’t reduced risk taking at less regulated institutions. U.S. lawmakers are considering also naming large asset managers systemically important enough for Federal Reserve oversight.

“Risk taking has moved away from investment banks to the non-bank market makers, which have full freedom to lose their capital if they get it wrong,” said Frederic Ponzo, managing partner at financial consultancy Greyspark Partners in London, which advises banks. “If that build-up of counterparty risk is not accounted for and managed, you may move the problem out of banks to somewhere just as systemically important.”

Default Protection

Investors including Pacific Investment Management Co. have sold a collective $4.5 trillion of default protection to banks and bought $4.3 trillion of insurance, DTCC data show, as they seek to boost income after six years of interest rate suppression by central banks.

With corporate bond yields approaching record lows and the supply of debt issued by sovereign, corporate and other borrowers forecast to fall $460 billion short of demand this year, the derivative contracts are quicker, easier and cheaper to trade than the debt they’re tied to.

“We use credit derivatives instead of buying bonds when they are cheaper than bonds,” said Eve Tournier, London-based head of European credit at Pimco, which manages $1.9 trillion of assets. “In addition, they offer better liquidity, you can do bigger size and there’s often a tighter bid/offer spread. We collateralize the trade, so we’re taking the same risk, just through credit derivatives instead of bonds.”

Annual Premiums

Asset-management industry executives told the U.S. Financial Stability Oversight Council that their firms aren’t systemically important because unlike banks, their funds aren’t backed by government guarantees. Fund companies don’t make large trades with their own assets, and clients direct their investments and can withdraw them at any time.

In credit-default swaps, sellers receive annual premiums in return for agreeing to pay the buyer of protection an amount covering losses should a borrower fail to meet its debt obligations.

The majority of trading is done on benchmark indexes and there’s a total $82.7 billion of protection outstanding on the current version of the Markit iTraxx CDX North America Investment-Grade Index of swaps on 125 companies from Alcoa Inc. to Xerox Corp., compared with $67.4 billion a year ago.

“More people are using derivatives right now because of low rates,” said Ashish Shah, global head of credit strategies at AllianceBernstein LP in New York. “More funds want to have derivatives in their portfolios because it gives a greater level of liquidity.”

AIG Implosion

The dangers of selling default protection were exposed in 2008 when American International Group Inc. imploded in the wake of the financial crisis. Wrong-way swap bets prompted a $182.3 billion government bailout of the New York-based insurer and spurred leaders from the Group of 20 nations to agree to push most trading through central clearinghouses and onto regulated platforms.

Legislators say the changes will enhance their ability to monitor risk taking, curb market abuse and make it easier to identify holdings when a financial institution fails.

Central counterparties cleared 26 percent of credit-default swaps at the end of last year while agreements to offset trades cut the value of outstanding contracts by 21 percent, the Bank for International Settlements said in a May 15 report. The gross notional size of the market has shrunk to $19.9 trillion from more than $60 trillion in 2007.

Swap Execution

Reforms are furthest along in the U.S., where the Dodd-Frank Act requires benchmark indexes to be traded on swap execution facilities, or SEFs, which give investors the opportunity to buy and sell contracts with each other rather than banks.

As a result of this, trades between money managers almost tripled to $717 billion in the past year, DTCC data show, while a retreat by investment banks cut their business by $4.7 trillion to $10.5 trillion.

“The cost for banks to hold derivatives on their balance sheets is increasing and some banks are reducing derivatives risk,” Renaud Tourmente, the Paris-based head of corporate credit at AXA Investment Managers said in an interview. “Investors are searching for yield and are willing to explore all parts of the market.”

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