Reply #37: The new frontier for derivatives (This sounds scary)

[54anickel]

http://news.ft.com/cms/s/a370fac6-cf24-11da-925d-0000779e2340.html

The race to capture a slice of the next frontier in the booming derivatives market is on, but banks and investors must overcome obstacles before credit default swaps of loans can take off as an asset class.

The explosive growth of the CDS market has changed the way the bond market operates. CDS let investors hedge exposure to bonds and have made it possible for investors to “short”, or bet on bond prices falling in value, as CDS prices tend to rise when a company’s credit quality deteriorates.

The banks also benefit from being able to transfer risk off their balance sheets by selling the risk of default to investors.

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A key difference between regular default swaps and loan CDS in Europe is in the documentation. While CDS contracts reference all outstanding bonds of a company, the reference obligation of a LCDS contract is one specific loan.

In the European market the LCDS contract terminates if a company buys back, or calls, the loan. Investors who want to retain exposure to the name in the derivatives market will have to buy a new LCDS contract.

In the US, the LCDS contract is transferred to another loan by the same company if the loan is called, so the contract “sees through” a refinancing. This is not the case in Europe yet, but banks have agreed to start using US-like documentation by next year. The International Swaps and Derivatives Association has yet to come up with standard documents to aid the development of LCDS.

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