Credit derivatives were first traded sporadically at the end of the 1980s but it was not until the early 1990s that a real market for these products began to emerge. In the late 1990s and the first half of the next decade, credit derivatives grew rapidly to achieve a central role in the financial markets.

The purpose of a credit derivative is to transfer only the credit risk of a borrower and not the associated interest rate risk. The fact that credit risk can be traded in isolation makes credit derivatives a very powerful tool.

The main types of credit derivative products are single name credit default swaps, credit derivative indices, index tranches, synthetic CDOs and CPPI.(See ‘the products’, page 17).

Unlike bonds and loans, which are financial contracts between a borrower and a lender, credit derivatives are contracts between any two counterparties which reference a specific borrower (the ‘reference entity’). Very often neither counterparty is a lender to the reference entity. The reference entity is rarely involved in the trade and usually has no reason to know that the credit derivative contract exists.

All credit derivatives traded to date (mid-2006) have been over-the-counter (OTC) derivatives. Unlike many equity or commodity options and futures, they are not traded on an exchange but are simply private contracts between two counterparties – one of which is usually a dealer (also called a market maker).

Highlights in the evolution of the credit derivatives market

Late 1980s

First cashflow CDOs issued

First credit derivatives begin to be traded, often swaps on specific bonds created for tax or regulatory purposes

Mid to late 1990s

Issuance of large balance sheet synthetic CDOs for the purpose of achieving regulatory capital relief

1996

Isda publishes the first credit derivative definitions

July 1999

Isda publishes the second credit derivative definitions, which bring much greater standardisation and acceptance to the market

September 2000

Bank of America extends the maturity of a loan to Conseco, triggering a  controversy which eventually leads the market to change its definition of restructuring as a credit event

December 2001

Default of Enron, the biggest corporate default in history by volume of debt outstanding

December Default of Argentina, the biggest sovereign default in history  by volume of debt outstanding, triggering a controversy on the  definition of repudiation/moratorium, the main credit event for  sovereigns

April 2002

Morgan Stanley launches Synthetic Tracers, which becomes the  market standard index for North American investment grade credit

Dealers launch the reference entity database (Red) in response to high  profile cases in which counterparties had disagreed over which was  the intended reference entity in a credit default swap. The project is  later taken over by data company Markit.

December 2002

North American dealers begin trading credit derivatives with standard  maturity and payment dates in an effort to increase liquidity. European  dealers later also adopt this practice

March 2003

Isda publishes 2003 credit derivative definitions, which significantly  revise the 1999 short-form documentation in areas such as  restructuring, successor events and guarantees

April 2003

JP Morgan and Morgan Stanley kick-start credit index trading in  Europe by merging their proprietary indices to form Trac-x

October 2003

North American dealers launch CDX NA IG, which takes over as the  standard credit index for North American investment grade

April 2004

Credit derivative dealers agree to merge various indices to form a  single index in each market

April/May 2005

A dramatic repricing of credit index tranches causes losses to banks  and hedge funds

May 2005

Default of Collins & Aikman, the first credit event to be settled using an  auction

June 2005

Isda launches standard documentation for credit default swaps on  asset-backed securities

September 2005

The New York Fed hosts a meeting between top credit derivative  dealers and regulators from around the world, who are concerned  about the operational weaknesses of the credit derivatives market.  Dealers agree to take steps to cut the time it takes to settle trades.

October 2005

Default of Delphi, thought to be the biggest default to date in terms of  credit derivatives outstanding