noting that, in most cases, the participant's firm dealt with the same counterparties as they did 5 years ago—although often in the form of newly-established "hedge funds" often affiliated with major investment banks.
Although informational limitations hinder quantification, some regularities appear to exist with respect to the end users of EMCD products. Anecdotal evidence suggests that commercial banks are generally net credit "protection buyers" (see product descriptions above) – using credit derivatives to manage balance-sheet risk, while investment managers are generally net "protection sellers" – using credit derivatives as an efficient means to establish potentially profitable "synthetic" exposures to underlying credit risks. By contrast, commodity traders, investment banks, and hedge funds regularly take different sides to transactions, driven by their particular market views and trading strategies.
The interview results, however, suggest that the market making activities of both commercial and investment banks dwarf their hedging or balance sheet management uses by such institutions. While detailed data are not available, EMCD market making appears to be dominated by four or five major dealers.
Product Effectiveness in Management of Country Risk
In general, the discussions found that current EMCD activity by banks is dominated by trading and market making. By contrast, hedging of balance sheet risks appears relatively limited, reflecting restricted EMCD liquidity—especially for corporate names—and other limitations inherent in credit derivatives as a risk management tool.
In terms of hedging, banks reported that sovereign credit default swaps are often used to hedge non-sovereign exposures, given the limited liquidity in credit derivatives for all but the largest "quasi-sovereign" corporate names. However, sovereign credit default swaps generally only offer effective hedges in cases where a bank's non-sovereign exposures are well-diversified— and are therefore broadly correlated with underlying sovereign risk rather than tied to individual issuer risk. Importantly, banks appear to limit buying credit default protection from local market providers, and assess the sophistication and extent of local exposures of counterparties (particularly hedge funds) to minimize counterparty risk.
Banks expressed greatest interest in the use of credit derivatives to manage country risk (compared to alternative forms of protection, such as political risk insurance or NDFs), citing their flexibility and improvements in standard contractual language, and their relatively broader coverage of risks.6 Credit derivatives could transfer only a limited set of "country" risks however. In particular, many important risks associated with direct financial sector investment by banks in emerging markets—including currency, convertibility, political and legal risks—are at best only imperfectly hedgeable through credit derivatives.
Beyond this, participants noted a number of product and emerging market-specific issues that place important limitations on potential growth of the EMCD market, particularly with respect to corporate credits. These mainly included diminished liquidity stemming from informational issues and a lack of depth reflecting a typically insufficient local emerging market investment
6 In this vein, credit default swap documentation typically provides that the protection seller assumes the risk of loss should different types of country risk events result in a reference entity's default on an obligation -for example, if the reference entity claims that it is illegal or impossible to pay, if there has been a change in applicable law or rule, of if exchange controls or capital restrictions have been imposed. See Section 4.1 of the 2003 ISDA Credit Derivatives Definitions.