The Promise of Credit Derivatives in Nonfinancial Corporations (and Why It's Failed to Materialize)

Although industrial companies played a big part in the growth of foreign exchange, interest rate, and commodity price derivatives, such companies have had almost no role in the growth of credit derivatives. As the authors point out, industrial corporates are exposed to credit risk in a variety of ways, including customer accounts receivable, longer‐term supply contracts, loans to customers and vendors, and counterparty exposures. Credit derivatives, moreover, would allow corporate users to avoid a number of drawbacks associated with other methods for managing credit risk, including credit insurance, factoring, and surety bonds or securitization. But, as both surveys and interviews with credit derivatives dealers suggest, corporates' direct use of credit derivatives has been very limited, accounting for less than 5% of the credit protection purchased using credit derivatives. As the surveys and interviews also indicate, there are a number of reasons why corporates may be reluctant to use credit derivatives: (1) Unlike the cases of interest rate or currency risk, credit risk management is typically the purview of business units rather than the corporate treasury, and the business units tend to have considerably less experience with derivatives. (2) The protection provided by a credit derivative is unlikely to provide a perfect match for the loss that would be suffered by a corporate in the event of a default. (3) The liquidity in credit derivatives tends to be greatest in maturities that are much longer than those of most corporate credit exposures. (4) It is harder for a corporate to determine how much protection to buy than for a financial. (5) While the existing credit derivative documentation (which is based on loans or bonds) works well for banks and investors, it is less satisfactory for the credit risk faced by corporates, which is often based on “payment.” (6) While accounting standards require that credit derivatives be marked to market, the inability of corporates to mark to market their underlying exposure being hedged leads to unwanted volatility of earnings. Nevertheless, as the authors predict in closing, if the corporate demand for credit risk transfer becomes large and urgent enough, these obstacles will likely turn out to be temporary roadblocks.