The Credit Derivatives Market – A Threat to Financial Stability?

Credit derivatives occurred as a solution to the needs of managing credit risks by the financial institutions, mainly banks. Besides the role of means of hedging and diversifying credit risks, derivatives become tempting for those likely to take on more risk to make more money. Therefore, the users of credit derivatives for protective purposes were outnumbered by the speculative ones. The result consisted in an ever-growing OTC market, with huge volumes traded. The players achieved very high leverage on increased credit exposures, without being suspected by creditors or regulators of inconsistency. The very first signs of the current global crisis revealed the weaknesses of the relations and dependencies developed on the credit derivatives markets, as big players on these markets have failed. This paper considers the benefits of credit derivatives for risk management, along with the perils they pose for systemic risk. Finally, the paper outlines the actions that should be undertaken in order to strengthen the operational efficiency of credit derivatives markets so as to ensure that they do not harm financial stability.