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An Overview of the Emerging Market Credit Derivatives Market

B. Gerard Dages, Damon Palmer, and Shad Turney Federal Reserve Bank of New York May 2005

Executive Summary

In conjunction with the Committee on the Global Financial System work group project on foreign direct investment in emerging market financial sectors, staff of the U.S. Federal Reserve Bank of New York reviewed in some detail the market for emerging market credit derivatives ("EMCD") and their use by banks to hedge emerging market credit risks. This note provides a brief overview of the development and characteristics of this market, and highlights relevant findings from our discussions with U.S. commercial and investment banks active in the market.1

In short, the EMCD market has grown rapidly in a short period of time, and market participants contacted for this survey were optimistic about its future expansion. However, the market also appears to face a number of challenges—reflecting accounting, legal, disclosure, and liquidity issues characteristic of a number of emerging market countries—that appear to prevent more extensive use of EMCDs by banks as balance sheet management tools. That said, EMCD were viewed more positively than alternative forms of country risk mitigation (such as political risk insurance or nondeliverable forwards), with participants citing the relatively broader coverage of risks provided for by EMCD.

Product Description

The emergence and application of EMCDs parallels that of the broader credit derivatives market in the second half of the 1990s.2 In their various forms, EMCD essentially involve the bilateral contractual transfer of credit risk on an underlying class of reference obligations of a particular reference entity (sovereign or corporate) between participants. EMCD allow a range of investment and hedging opportunities to participants, some examples of which include: alternative tenors than those available in the cash market; directional and relative value trades; leveraged plays; hedging of bank lending to emerging market borrowers (while maintaining client relationships); creating/hedging bond positions by mutual funds and pension funds; and alternative investments by local financial institutions and investors, particularly in shorter-dated instruments.

The most common products include credit default swaps, credit-linked notes ("CLNs"), OTC deposits, and synthetic collateralized debt obligations ("synthetic CDOs"). Credit default swaps are the most basic EMCD product and involve payment of a premium by one counterparty (protection buyer) in exchange for a contingent payment by another (protection seller) in the event of a specified credit event vis-à-vis a reference obligation or entity (typically, but not exclusively, sovereign bonds or bonds of blue-chip corporates). Credit default swaps are based

1 This note reflects the findings and judgments of the authors and not necessarily the views of the Federal Reserve Bank of New York or the Federal Reserve System. The authors gratefully acknowledge the comments of Diane V i r z e r a i n t h e d e v e l o p m e n t o f t h i s p a p e r . 2 For an overview of the global credit derivatives market, see British Bankers' Association Credit Derivatives Report 2003/2004, or FitchRatings “Global Credit Derivatives: A Qualified Success,” September 24, 2003. For more detail on emerging market credit derivatives, see in particular the May 1, 2003 report by Deutsche Bank, “Emerging Market Credit Derivatives: Market Overview, Products, Analyses, and Applications.” The latter is one of the few such analyses, and was a significant source of information for this overview.

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