De Rerum Derivativum

Last time I referenced the (electrifying) 19th edition of Scott & Gelpern’s International Finance, Transactions, Policy, and Regulation, it was to make a facetious point about the SEC. This time, it’s to…well…I’m not entirely sure what the point is. But I’m pretty sure it’s an interesting one.

On page 963, in the context of a section more generally aimed at describing the various factors which could motivate a firm to engage in derivatives transactions, we get the following observation in a set of paragraphs following the assertion that “a major reason for entering into swaps” is to reduce funding costs:

“A Federal Reserve Board study found that the credit rating of firms reporting OTC derivatives that have a senior debt rating is significantly better than that of all firms with senior debt ratings. Indeed, the ratio of expected default rates for the typical derivative user to the typical firm representing all the firms in the sample was almost exactly one half.”

Given the context, it reads like the superior credit ratings of firms reporting OTC derivatives are supposed to be understood as deriving from the firms’ use of OTC derivatives (presumably because they are being intelligently employed to hedge risks). But there’s no obvious causality one way or the other. What if all this is telling us is that the market is only willing to provide derivatives to firms it doesn’t expect to default in the first place?*

And then, lo and behold, a few pages later (page 968 if you’re scoring at home) the authors inform us that, “Most swappers insist on double A or better credit ratings for counterparties.” Huh. I imagine if you were looking for evidence that the association of OTC derivatives with better credit ratings was indicative of markets’ preference for customers (and not the all-healing powers of CDS, say), it would (or at least could) look something like this.

I don’t raise this because I am anti-derivative, or anti-CDS, or up in arms about the “banksters”.** People much smarter than I am tell me CDS are useful hedging tools and instruments of risk management. I believe them! It just seems like an odd editing choice, to say the least. Or, if you wanted to put on your conspiracy theory hat, you could say it was a deceptive attempt to secretly bolster support for legislation favorable to financial derivatives amongst America’s budding lawyers by misleadingly portraying these derivatives as the financial equivalent of penicillin. But Occam’s Razor would suggest there’s a good explanation for all of this, and that I just don’t know what it is.

*I mean, I’m sure I’m missing something, and this isn’t what’s happening, but on the other hand, that seems like a more plausible story to me than one in which companies with relatively worse credit profiles go out and engage in all kinds of complex derivatives-based hedging and come out of it with relatively improved profiles
**According to Wiktionary, the portmanteau was coined by a Belgian