Concentration risk remains high in the global credit derivatives market despite its rapid growth, and settlement risk has become an increasingly important issue, too, warns Fitch Ratings.

In its annual global credit derivatives survey published today, the rating agency found that the credit derivatives sector almost doubled in size in 2004, totalling US$5.4 trillion at year-end 2004, up from US$3.0 trillion in 2003.

“Although banks use the credit derivatives market to transfer risk, the top 15 global banks and broker dealers held 75% of gross sold and 81% of gross bought positions at year-end 2004. The market making function in relation to credit derivatives is therefore highly concentrated and market liquidity could be vulnerable should one or more of these institutions choose to withdraw from the markets or encounter a problem,” said Ian Linnell, managing director, Fitch Ratings.

The top four counterparties were Deutsche Bank, Morgan Stanley, Goldman Sachs, and JPMorgan Chase.

“The market also has to confront the issue of settlement risk following the occurrence of several high profile credit events and the significant increase in trading volumes,” said Krishnan Ramadurai, senior director, Fitch Ratings. “We believe that these issues have highlighted the potential need for greater standardization of settlement procedures.”

Credit derivatives’ growth continues to be driven by single-name credit default swaps. The global banking industry increased the amount of protection it bought in 2004 by 40% year-on-year to a net position of US$427 billion, Fitch reported.

Insurance companies and financial guarantors were large net sellers of protection at US$556 billion, up 21% on 2003. Of that total the global insurance sector once again emerged as the largest seller of protection on a net basis with an exposure of US$319 billion. Although AIG Financial Products Corp dominates that total with net exposure of US$268 billion, Fitch expects the wider insurance sector to gain increasing prominence in the credit derivatives market.

The report also notes that most financial institutions find it difficult to meet the accounting standards’ hedge-accounting requirements for CDSs treated as derivatives. More importantly, the agency found that the on-balance sheet treatment of CDSs at fair values is often difficult to determine, which combined with poor disclosure leave it with virtually no insight into whether risk has actually been transferred from the balance sheet of an institution.