This interview, conducted shortly after the Atlanta Fed's 2007 Financial Markets Conference, discusses credit derivatives and their importance to the market and outlines key themes of the conference.Credit derivatives ; Risk

Paula Tkac

English

Research Papers in Economics

v ECONOMIC REVIEW Fourth Quarter 2007
M
oderator: Welcome to Research Insights, a podcast from the Federal Reserve
Bank of Atlanta. Our topic today is credit derivatives. . . . Our first question
is, What are credit derivatives?
Tkac: . . . Credit derivatives are a relatively recent financial innovation that effec-
tively shifts credit risk, or the risk of default, from one party to another. The vast
majority of credit derivatives are actually known as credit default swaps, and I think
it might help if I give you a simple example.
[S]uppose you want a bond, issued by a major corporation, such as GM or IBM.
You’re exposed to credit risk in the sense that if the corporation defaults on its bond
payment, your bond decreases in value or becomes worthless. A credit default swap
allows you to transfer this credit risk to another market participant for a price.
Essentially, you pay a yearly fee to your counterparty, and they agree to pay you the
par value of the debt in the case of default. Credit default swaps can also be written
on sovereign debt of a nation, baskets of corporate bonds, indexes of debt-issuing
corporations, and even tranches of these indexes. The market has grown rapidly in
the past decade or so and has gotten increasingly complex as we’ve moved ahead.
Moderator: . . . Why do credit derivatives matter to financial markets?
Tkac:. . . I think the first reason is, as I mentioned, the large growth in the market.
As of 1997, there was $180 billion in credit default swaps traded. That ballooned to
over $20 trillion in 2006, so the sheer magnitude of the trade in these instruments
reflects the value of this innovation to market participants but also causes us to want
to look at them a little more closely.
I should mention [that] the major participants are banks, hedge funds, and insur-
ance companies. Conceptually, any innovation like this that unbundles risk allows
Preface—Credit Derivatives: 
Where’s the Risk?
PAULA TKAC
Tkac is an economist and associate policy adviser in the Atlanta Fed’s research depart-
ment. The following text is adapted slightly from an interview with Tkac recorded shortly
after the Atlanta Fed’s 2007 Financial Markets Conference, “Credit Derivatives: Where’s the
Risk?” held May 14–16. The interview is part of the Atlanta Fed’s Research Insights podcast
series. To listen to this podcast or to subscribe to any of the Atlanta Fed podcast series, visit
www.frbatlanta.org and click “Podcasts” on the home page.
FEDERAL RESERVE BANK OF ATLANTA vi ECONOMIC REVIEW Fourth Quarter 2007
these risks to be priced more efficiently. This [efficiency] allows participants to hedge
and allows capital to flow more freely to its highest-valued use [and thus] has great
benefits not only for financial markets but for our economy more generally.
However, there are some concerns or potential for what we call “systemic risk”—
the risk of spillovers of any kind of adverse event in this market to the larger finan-
cial market. The reasons that there are some concerns are, one, that these contracts
are largely bilateral. They’re under the radar. They’re agreed to by two individual
counterparties, not regulated through any exchanges. They involve a large notional
amount. That means the value of the credit default swaps being traded out there is
some fourteen to eighteen times the value of the underlying bonds on which these
instruments are written. In addition, the participation of hedge funds causes some
concern because, again, hedge funds largely operate under the regulatory radar, and
so we’re never certain from a policy perspective exactly what risks are being taken
and whether they’re being effectively monitored.
Finally, this market has largely been untested. We’ve been through a very posi-
tive credit environment recently, and we don’t really know what will happen if there
is a major credit event on a large scale and how that might ripple through the finan-
cial system.
Moderator: . . . [Y]ou just got back from the Atlanta Fed Financial Markets
Conference. Fed Chairman Ben Bernanke spoke there. There were other partici-
pants including policymakers, academics, and market participants. What were
some of the main points that were raised at this year’s conference?
Tkac: [W]e spent a lot of time talking about both the risk management and, at indi-
vidual firm level, the important things that market participants need to do to manage
and evaluate their risk when trading these instruments. But [we also discussed] the
risks at the systemic or macro level in terms of understanding the integrity and sta-
bility of the financial system and how credit derivatives and credit default swaps play
into those concerns. [T]wo points that I would like to mention as probably most
important coming out of the conference [are], first, [that] we heard from many prac-
titioners and policymakers about the role of financial market participants themselves
in monitoring and evaluating and managing their own risk—not only the risks of the
instruments that they’re holding, but importantly, for systemic reasons, the risk of
their counterparties and their potential distress. So, when you trade with another . . .
entity [that] has distress or losses and can shut down and can’t meet [its] obligations,
that may spill over onto your concerns, and that’s where we worry about this domino
effect being more pervasive.
So . . . what we heard was that each individual market participant has a great
incentive to evaluate and monitor and manage [his] own risk and exposure, and this
is a powerful market-centered force to help us in constraining the potential for sys-
temic risk. And indeed the industry itself has taken steps to improve back-office
clearing and settlement, to move to auction and cash-based settlement, away from
the physical delivery of bonds. All of these contribute to the integrity and stability of
the market for credit derivatives. 
Second, I’d like to reference Chairman Bernanke’s remarks. He spoke more gen-
erally and brought up, I think, some very important points about regulating financial
innovations such as credit derivatives. He noted that consistency and a principles-
based paradigm for the regulation of innovations is important for achieving three
public policy objectives: financial stability, investor protection, and market integrity.
FEDERAL RESERVE BANK OF ATLANTA This [approach] is in contrast to a more rules-based approach or an ad hoc approach,
which might regulate each instrument as it becomes available. As we all know, regu-
lating in a rule-based fashion only encourages market participants to innovate and
behave in response to those rules in ways [that are] sometimes . . . adverse to the initial
policy objective. So Chairman Bernanke’s remarks, I think, provide a good roadmap
going forward as the market continues to innovate.
vii ECONOMIC REVIEW Fourth Quarter 2007
FEDERAL RESERVE BANK OF ATLANTA 

Preface - credit derivatives: where's the risk?

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