Unbundling Credit Risk: The Nature and Regulation of Credit Derivatives

Journal of Banking & Finance Law and Practice, Vol. 11, June 2000

Posted: 14 Apr 2001

See all articles by Paul Ali

Paul Ali

University of Melbourne - Law School

Abstract

Credit derivatives are transforming the ways in which banks and other financial institutions manage credit risk. In contrast to traditional methods of credit risk management, such as loan syndications, risk participations and conventional asset-backed securitisations, credit derivatives permit financial institutions to unbundle and separately lay-off the credit risk on their loan and bond portfolios and trading books.

This article explains the legal structure of the main types of credit derivatives (credit default swaps, credit spread products, total rate of return swaps, and credit-linked notes) and examines the key regulatory issues facing credit derivatives in Australia.

The first of these issues relates to the status of credit derivatives under the Australian Corporations Law, that is whether such derivatives are "futures contracts". Parties who deal in or advise on futures contracts are subject to licensing requirements. In addition, futures contracts can only, under the Corporations Law, be transacted on a futures exchange or in a specifically exempted futures market. Failure to comply with these requirements attracts both civil and criminal penalties. The question of whether a credit derivative (or any other derivative) is a "futures contract" will, if the reforms proposed in the Financial Services Reform Bill 2000, are enacted be superseded by the question of whether a credit derivative is a "financial product". A party who deals in or advises on financial products will be subject to licensing requirements. In addition, parties who conduct markets in financial products will be required to hold a new financial product market licence. Again, non-compliance with these licensing requirements will attract civil as well as criminal penalties.

The status of a credit derivative as a futures contract or a financial product also has significant implications for the application of the Australian gaming and wagering legislation. Futures contracts enjoy the benefit of a statutory safe harbour from that legislation. This protection has also been extended to financial products under the Financial Services Reform Bill.

Finally, there is a concern that credit derivatives are contracts of insurance under Australian law and, consequently, that a dealer in credit derivatives will be considered to be conducting an insurance business. Parties, who carry on an insurance business in Australia, must, under the Australian Insurance Act 1973, be formally authorised to do so by the Australian Prudential Regulation Authority. A party that breaches this requirement will be subject to criminal penalties. In addition, it is likely that, in these circumstances, the credit derivatives transacted by the dealer will be unenforceable.

Note: This is a description of the article and not the actual abstract.

Keywords: Derivatives, Credit Derivatives, Regulation of Derivatives, Futures Contracts, Insurance, Gaming and Wagering Contracts, Credit Default Swaps, Credit Spread Options, Total Rate of Return Swaps, Credit Linked Notes, Securitisation

JEL Classification: K22, G18, G21

Suggested Citation

Ali, Paul, Unbundling Credit Risk: The Nature and Regulation of Credit Derivatives. Journal of Banking & Finance Law and Practice, Vol. 11, June 2000. Available at SSRN: https://ssrn.com/abstract=263612

Paul Ali (Contact Author)

University of Melbourne - Law School ( email )

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HOME PAGE: http://www.law.unimelb.edu.au

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