The phenomenal growth of the derivatives markets in the last decade and the spate of huge losses there have highlighted the importance of risk management. To respond to customers' concerns about the credit risk of intermediaries in these markets, some U.S. securities firms and non-U.S. banks have created subsidiary derivative product companies (DPCs) that are specially structured to function as intermediaries with triple-A credit ratings. These "structured" DPCs obtain these ratings because of the way in which they manage risk.
The structured DPCs have developed approaches to managing two basic types of risk-market risk and credit risk--in an effort to minimize capital while maintaining triple-A ratings. In particular, the DPCs hedge market risk as fully as they can, typically by means of mirror transactions with their parents. To manage credit risk, DPCs use quantitative models so that they can measure credit exposures precisely and allocate capital to cover just the risks measured in a given day. In addition, the DPCS have a contingency mechanism in place that would limit the risk that would arise should their regular risk management structure break down.
As subsidiaries of securities or banking firms, structured DPCs are organized to secure credit ratings that substantially exceed those of their parents. The nine such DPCs currently operating around the world are rated Aaa by Moody's Investors Service and AAA or AAAt by Standard and Poor's, the highest ratings of these agencies, despite parents with no rating above single-A (Table 1) The first such DPCs were designed to achieve triple-A ratings because it was thought that many customers would insist on dealing only with the most highly rated intermediaries. In 1995, however, four years after they first emerged, the structured DPCs still accounted for a relatively small share of markets in which the major intermediaries generally had substantially lower credit ratings. Are the DPCs getting off to a slow start or are they structurally inhibited from more significant market expansion?
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In this article, we explore the DPCs' approaches to risk management and the extent to which these approaches provide competitive advantage. We begin by characterizing the major intermediaries in the derivatives markets and describing how they manage risk. We then discuss the emergence of structured DPCS and their approaches to managing risk, and explain how the approaches minimize the capital required for triple-A ratings. Finally, we discuss the possible reasons why, despite these ratings, DPCs have not succeeded in taking a larger share of the derivatives markets.
THE MAJOR INTERMEDIARIES IN THE DERIVATIVES MARKETS
Over the pass few years, six U.S. money-center commercial banks and two U.S. securities firms have been the dominant intermediaries in the over-the-counter markets for derivatives, with each having a derivatives book exceeding $1 trillion in notional value at year-end 1994 (Table 2). Together, the six banks accounted for a total of $13 trillion, or about one-third of the global over-the-counter derivatives markets, which total perhaps $40 trillion in notional value. Even the smallest derivatives book held by these banks was sizable, approaching a notional value of $1.3 trillion at the end of 1994. The two securities firms are also major players, having the fifth and seventh largest derivatives books in the markets when ranked with the banks.
DERIVATIVES AND CREDIT RATINGS OF MAJOR U.S. COMMERCIAL BANKS AND SECURITIES FIRMS
Notional Value Rating
Institution (Billions of Dollars) (S&P/Moody's)
Chemical Bank 3,178 A+/Aa3
Citibank 2,665 A+/A1
Morgan Guaranty 2,473 AAA/Aa1
Bankers Trust New York 2,026 A+/A1
BankAmerica 1,401 A/A2
Chase Manhattan Bank 1,306 A/A2
Salomon Brothers 1,509 A-/A3
Merrill Lynch 1,300 A+/A1
Source: Annual reports for 1994. …