It was the new international rules of the Basle Accord, 1988 that brought credit derivatives into existence. The Basle norms required banks to set aside some part of their capital against their loans. Banks seeking to reduce their exposure and related risk-based capital requirements to corporate credits have found credit derivatives to be more efficient than traditional securitizations. A credit derivative is a financial instrument used to mitigate or to assume specific forms of credit risk by hedgers and speculators. They are particularly useful for institutions with widespread credit exposures. It has the potential to herald a new form of international banking in which banks resemble portfolios of globally diversified credit risk more than purely domestic lenders. Today credit derivatives represent one of the fastest growing businesses in banking. (See box ‘The wonderful idea of pedaling risk’ for a detailed account of credit derivatives market).

In any financial transaction the two primary types of risks faced by firms are market risk and credit risk. When the changes of interest rates, exchange rates, stock prices or commodity prices affect the firm’s value it is market risk. However, when the firm fails to meet obligated payments of counterparties on time it is credit risk or default risk. The degree of risk is reflected in the borrower’s credit rating, which defines the premium over the riskless borrowing rate it pays for funds and ultimately the market price of its debt.

Credit risk has two variables: market risk and firm-specific risk. Credit derivatives allow users to isolate, price and trade firm-specific credit risk by unbundling a debt instrument or a basket of instruments into its component parts and transferring each risk to those best suited or most interested in managing it. Generally, firms enter into offsetting or hedging transactions to manage market risk. However, managing firm-specific risk is not that easy. Though banks and other financial institutions have dealt with credit risk for decades, the methodology used in the past was neither very sophisticated nor well suited to meet the needs of the present changed world. Today the financial markets deal with highly leveraged derivative transactions, often involving a multiplicity of parties and being determined by a large number of market variables. It was only when the over-the-counter derivatives activity accelerated the importance of efficient management of credit risk was realized.