According to a survey conducted by the British Banker's Association (BBA), the global derivatives market grew by $1.189 trillion this year, and the growth rate for the market is predicted to almost double, hitting up to $4.8 trillion by 2004. The market's evolution lays down a staggering pace, illustrating the increased application of credit derivative technology to European market transactions.

The volume of credit derivatives is globally immense. However, it is difficult to derive exact figures, as a large component of the market is private. The number of active counterparties in Europe, at about 30 to 40, is far higher than in the U.S. The BBA survey shows that over half of the market volume is originated in London, which, by the end of the year, is expected to reach an estimated $1.036 trillion.

Credit derivatives and credit default swaps are being more widely used in European CDOs, particularly because these instruments allow market participants to distinguish between risk transfer and alternative forms of financing, said Stroma Finston, a director Standard & Poor's, during a conference in London last month.

"We started seeing the technology used to manage banks' balance sheets as a structuring tool, but the [European] market is starting to understand that credit derivatives are not confined to CDOs, but can also be effective in RMBS and CMBS structures," Finston said, adding that market players now view credit derivatives as an arbitrage tool and not just as a structuring tool.

At least 60% of publicly rated CDOs completed in the first half of this year were done on a synthetic basis. "This translates into $4 billion - a significant 48% increase over the $1.8 billion seen during the same period a year earlier based on S&Ps assessment of the European market," said the rating agency.

The technology was first applied on bank balance sheets as a structuring tool. It's a simpler transaction to structure because there is no transfer or sale of the assets. Recent developments of the credit default swap market has lead to transactions that are being completed for arbitrage purposes in jurisdictions outside of Germany and the Netherlands, where they are still used for balance sheet management. "People put together reference portfolios and they set a credit default swap over the portfolio that the rating agency rates," said one source. "This is really the area that has seen growth." The source added that static arbitrage trade is now evolving, however, to include an element of management allowing the manager to sometimes add and remove tools.

ISDA discord

Most of the trade seen in the European market is based on International Swaps & Derivatives Association (ISDA) documentation, and most market players feel that increased standardization will only aid in growing the market on equal footing. The problems associated with a lack of standardized documentation is demonstrated in the global debate over what constitutes a default, and the difference between "restructuring" and "modified restructuring."

According to the BBA survey, almost all of the 25 institutions participating thought that the debate over what counts as a default highlights the conflict of interest between the U.S. and the UK/Europe in the documentation of credit derivatives. Most U.S. sellers of credit protection offer protection against modified restructuring, whereas European players do not accept this standard. In Europe, many sellers of credit protection offer full loan restructuring protection.

Should the modified restructuring scheme be included in Europe? The market debate revolves around loan obligation vs. bond obligations and what would constitute a credit event. "Some respondents felt that U.S. institutions were trying to push the product as bonds, whereas Europe is looking for a practical means of crossing product boundaries, including loans," said the BBA. "There was a strong sentiment among survey participants that a new form of restructuring protection needs to be developed that meets the needs of both sellers and buyers of credit protection on a global level."

Market participants also said that the U.K. regulator, Financial Security Authority (FSA), was largely regarded as less knowledgeable of synthetic products than its U.S. counterpart. They also said that the lack of product knowledge on the part of clients might also be hindering the evolution of European markets.

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