base, but also, historically at least, uncertainty surrounding the definition of "credit events" triggering payment in standard credit derivatives contracts (particularly with respect to the application of "restructuring" credit events to sovereign credits).
At a general level, the global credit derivatives market remains by and large an investment grade market, with investment grade credits making up 84% of the universe of underlying reference entities in the overall market at the end of 2003.7 In part this stems from the informational needs of the rating agencies and of investors, which can be challenging in an emerging markets context.
In particular, participants explained that it is frequently difficult to get sufficient data to enable investors and other market participants to do comparative risk analysis for emerging market corporate borrowers as the largest corporate borrowers in emerging markets often bypass the local bank lending market and access funding primarily through international equity or bond markets. Hence sufficient loan-loss histories (company-specific and comparative benchmarks) are not available to properly analyze and price credit derivatives.
Particular informational difficulties arise in trying to structure credit derivatives covering "multiple-name" emerging market corporate credits, such as synthetic CDOs. These include both the lack of well-developed loan-loss history on corporate borrowers and the general overall "cloud of country risk uncertainty" that overshadows analysis of specific company credit risks— with synthetic CDOs generally requiring credit ratings and credit loss histories—both of which are difficult in the emerging market context.
Described differently, typically there is insufficient i) default history, and ii) portfolio diversification to construct emerging market synthetic CDOs. Given the high correlation of emerging market risk, even with 100 different corporate names from different countries in a CDO, the effective number of uncorrelated credits would typically be closer to one-tenth of this amount. As a result, an emerging market CDO requires a much higher "first loss" or "equity" tranche retained by the sponsoring bank (typically 18% versus 2-4% typical in developed markets, according to one market participant) to make the CDO marketable—hence usually rendering it uneconomical for the sponsor.
A more fundamental constraint on EMCD market development concerns shallow local savings and markets for the financing of local companies. A larger pool of investible funds would open up significant demand for hedging and investment opportunities.
An additional challenge has stemmed from uncertainty surrounding interpretation of the definition of the "Restructuring" credit event.8 The 1999 Restructuring definition (so-called "full" Restructuring) generally reflected revisions to address ambiguities that the 1998 Russian default revealed—including whether the Russian domestic debt "reinvestment" program constituted a Restructuring event, whether the restructuring was "material", how deliverable obligations should be valued, and which obligations were covered. The 1999 Definitions sought to
7 8 BBA Credit Derivatives Report 2003/04, pg. 23 The standard "credit events" that trigger payment under emerging market credit derivative contracts are Failure to Pay, Repudiation/Moratorium, Obligation Acceleration, and Restructuring.