Derivative in Japan

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You can call it a another "flaw" in the "asian model." It certainly shows a lack of flexibility. Control, even in the name of commerce, is its own brake. Yet if you want to trade a credit crunch, and throwing in currency appreciation, spreading in favor of Japan may be just the ticket.


The explosive growth in credit derivatives is bypassing Japan. It accounts for 5 per cent of global activity, estimates the British Bankers' Association, compared with about 40 per cent for London. The BBA sees Japan's share rising by only a percentage point by the end of next year. This is largely structural. Japan Inc traditionally borrows from banks rather than the capital markets; the underlying corporate bond market is about a 10th the size of the US market. The "main bank" system, under which lenders prefer to waive debts rather than push borrowers into bankruptcy, is also responsible for the paucity of defaults: the last one was six years ago. Little wonder investors are not rushing to insure against that risk by buying credit default swaps.

Illiquidity combined with a shortage of higher-yielding paper means tight spreads. Even companies with an ostensibly risky outlook move within a relatively sedate range, aided by their ratings, which are often, surprisingly, investment grade. Take the beleaguered consumer finance industry, reeling under legal changes that radically undermine its profitability. Last week CDSs in three of the four top consumer finance names were trading at spreads lower, or just a touch tighter, than those of blue-chip US investment banks including Goldman Sachs and Morgan Stanley. Sure, that was an especially traumatic week, but even in more normal times spreads on iTraxx indices based on Japanese CDSs are sharply lower than US benchmarks.

Will the Japanese market grow? There are some hopes that the introduction of risk-weighted Basel II capital rules will stimulate the use of CDSs for hedging purposes. There is some evidence of this: the country's top bank last year issued a handful of balance sheet collateralised debt obligations referencing Japanese names. But do not bank on this starting a virtuous cycle of liquidity. Made-in-Japan CDOs are still more likely to involve overseas names, to pick up bigger spreads. This leaves Japanese hedge funds with one less weapon in their armoury.

Source Citation: "Japanese credit derivatives LEX COLUMN.(LEX COLUMN)(Column)." The Financial Times (March 14, 2007):
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