Credit Default Swaps Update

Changes to the CDS market

Since I wrote my earlier quick guide to credit default swaps (CDS) there have been changes to this market. These occurred in 2009 and are referred to as Big Bang. A summary is below.

Why change CDS?

Old style CDS have a design problem. If a dealer enters a trade and a week later offsets this with another trade the two trades are not perfectly matching. The differences include credit event dates, maturity dates, premium payment dates and premium amounts. This makes netting, trade compression and clearing problematic. These changes deal with those problems and some additional “plumbing” issues.

Effective date: With old CDS trades protection against a credit event started on the business day following the trade date. If you sold protection today and bought protection a week later you may have thought you were hedged but you may not have been. A credit event that occurred between the two contract dates would trigger the first contract but not the second. In order to overcome this problem CDS now have a “look back” feature. The effective date for a credit event is today minus 60 days and for succession events today minus 90 days. Every day this look back “rolls” forward one day. This means all trades, new and old, have the same effective date (t-60/t-90).

Determination committees (DC): There is one DC for each region (America, Asia ex-Japan, Australia & New Zealand, EMEA and Japan). Each DC is responsible for deciding whether a credit event has occurred. The DC then holds any auction and also decides on acceptable deliverable obligations and any substitute reference obligations. For a DC to judge whether a credit event has arisen an ISDA member must get the sponsorship of a DC member. The event must have occurred within the t-60 or t-90 time horizon (credit or succession event). If a credit event has occurred the DC specifies the deliverable obligations and also determines whether an auction is required.

Hardwiring the auction: Old style CDS used physical settlement - a process that could drive up the price of deliverable obligations. Since 2005 an ISDA protocol has led to auctions being used to determine the recovery rate on a defaulted entity. The mechanics of the auction process can be found at www.isda.org

Fixed coupons: Old style contracts quoted a varying credit spread as the price. This has been replaced by a fixed coupon. A fixed coupon improves standardisation and trade processing.

Single name CDS in North America now trade with a fixed coupon of 100bp or 500bp. This leads to upfront payments on CDS trades. 100bp fixed coupons (investment grade credits) are quoted on a conventional spread basis and 500bp (high yield credits) contracts quoted as “points upfront”. The market has adopted a standard pricing model that allows quoting conventions (spread and upfront payment) to be compared.

Interest Payments: In order to help matching and trade compression, premium payment dates now fall on IMM dates. That is 20th March, 20th June, 20th September and 20th December. A protection buyer now pays a full three month coupon on the next IMM date regardless of when the trade was done. This means that the protection seller must repay to the buyer the accrued interest from the previous coupon payment date to the trade date.

Quotations: The old style quote is a “par spread” ie the number of basis points paid or received to buy or sell protection. Using fixed 100bp or fixed 500bp means that dealers will need to be able to compare old style credit spreads with new style upfront payments (points). To avoid disputes the market has adopted the ISDA CDS Standard Model originally written by JP Morgan. (If there isn’t a standard model trade breaks are potentially more likely as dealers quote on a fixed 100/500 basis with the upfront payment being calculated subjectively).

Simplified example

You buy protection for $10m nominal on 8th July 2014
Maturity is 20th September 2019.
The conventional spread is 450bp
There is a fixed coupon of 500bp.

You will pay a full first coupon 20th June - 20th September 2014 on 20th September 2014.

The payment will be 10m x 5% x 92/360 = $127,777.77.

But 18 days have elapsed already (20th June – 8th July)

10m x 5% x 18/360 = $25,000.00 (you will want this accrual refunded)

The difference between the fixed coupon and conventional spread is 50bp or $50,000 per annum (the fixed spread you pay is 50bp more than the conventional spread you agreed).

That’s 5 years x $50,000 = $250,000 gross

Suppose the ISDA CDS model discounts this and calculates the PV as $222,500

In order to keep the net present value of the deal at zero you will want this as an upfront payment as well. So the total paid to you at the start of the deal is $222,500 + $25,000 = $247,500

In summary:

Conventional spread 450bp

Fixed coupon 500bp

Upfront $222,500

If upfront quoted as points -222.5 (paid by protection seller to protection buyer)

Accrued $25,000 (paid by protection seller to protection buyer)

First Published by Barbican Consulting Limited 2014