Credit Default Swaps

Market growth

The credit derivative market has been growing rapidly. The first transactions were initiated in the mid 1990s. In 2000 the market was estimated to be USD 0.9 trillion in size, by 2004 this figure had grown to USD 8.4 trillion. Estimates at the end of 2005 are for a market of USD 12 trillion. This growth may sound enormous but it should be put into context. The credit derivative market constitutes approximately 1% of derivative contracts traded by financial institutions.

So why the interest in credit derivatives?

Because it has been reported that financial institutions are making substantial profits from trading credit derivatives. And at the same time there have been concerns about how well credit derivative transactions are managed. Regulators in particular have taken interest in this growing market.

Anecdotal evidence would suggest that in some banks, credit derivatives constitute the main growth for traded products. And in these institutions credit transactions may account for 25%-50% of trading profits. There is no doubt that for some, credit has become a major source of income, (and risk).

What can you do with credit derivatives?

Credit derivatives can be used for several purposes. Here are some of their main uses:

Risk management & capital reduction: Credit derivatives can be used for hedging specific credit exposures, freeing up credit lines and reducing capital usage. Multiple credit exposures typically found in investment portfolios and on bank balance sheets can be hedged using collateralised debt obligations. This may lead to regulatory capital relief.
Investment: Credit derivatives can allow investors to increase credit exposures in order to obtain a return for the risks they take. There are many strategies that can be adopted. Some institutions simply sell credit protection in order to earn premium income. Credit derivatives also offer relative value strategies, leveraged trades and exposures to portfolios and indices.
Trading: Credit trading falls into two broad categories. First there is proprietary trading this includes outright long / short strategies and relative value trades. For the proprietary trader credit derivatives offer leverage. Second there is profit to be made from supplying liquidity. The market maker gains bid-offer spreads.
Structured products: Credit derivative markets now offer a whole series of structured credit trades. Whilst some of these trades are complex they do one thing- they provide traders and investors with tailor made risk exposures. Whether the trades are "fair-value" is another question.
Miscellaneous uses: These include hedging credit spread risks before issuance, hedging receivable risks and tax arbitrage.

Some of the concerns that face banks when trading credit products remain.

Two issues have been highlighted by regulators:

How will banks deal with a large number of transactions subsequent to a credit event?
Can trade processing be accelerated in order to clear up outstanding transactions between counterparties?

Users of credit products also need to consider what they are doing with them. In a relatively benign credit environment increasing leverage using credit derivatives will prove profitable. But in the long run this is not risk free. Only a genuine, well thought out business strategy will offer firms the best chances of success.

Users of complex or structured credit products should also ask whether they fully understand the nature of the risk they are entering into.

Many buyers of structured products including credit linked notes and asset backed transactions cannot accurately price or value the transactions. These products are sold on the basis of caveat emptor. Many of the valuation models rely on the user to input variables. Assumptions can cause significant errors.

How credit default swaps, (CDS), work

Credit default swaps are the vanilla or basic credit trading product. They allow credit risk to be bought and sold. Furthermore in order to trade CDS you do not need to own the underlying asset or credit exposure. Assets like bonds contain both credit risk and market risk so bonds are not "pure" credit trades. However by using CDS you can buy and sell credit risk in isolation. The underlying credit risk is known as the Reference Entity.

The credit default swap is a bilateral derivative contract; (the word "swap" is somewhat misleading. With CDS although the documentation refers to floating payments this is not Libor or Euribor, cash flows that people normally associate with an interest rate swap).

One party is the default protection buyer. This party pays a regular fixed premium to the other party who is the default protection seller.

The premium is expressed in basis points and is normally paid on a quarterly actual 360 basis. The payment dates may co-inside with the IMM futures payment dates. The dollar amount of the premium is calculated using the nominal or effective amount of the transaction.

The size of the premium is dependent on the credit risk, (a defined Reference Entity), and maturity of the CDS that is traded. The greater the perceived credit risk the higher will be the premium.

The credit default swap will have a maturity date. This is normally in the 3, 5, 7 or 10 year range. If there is no credit event the fixed premium will continue to be paid by the buyer to the seller until the maturity date. If there is a Credit Event the trade is settled and the premium stops being paid.

The floating payment is only triggered or paid if there is a credit event relating to the reference entity.

What does that mean?

If there is a credit event the CDS terminates. The fixed leg ceases and there is cash or physical settlement on the floating side of the trade. (Depending on the documentation that has been agreed the protection buyer may have to pay the accrued interest up to the date of default).

Credit events

What constitutes a credit event must be clearly defined. This is why ISDA produces standard documentation for these transactions. It helps avoid confusion. So when the counterparties enter the trade they must decide what credit events they wish to include.

Credit events that are frequently used are bankruptcy, failure to pay and restructuring, (all of these have specific definitions). It is also normal to have reference to publicly available information in order to demonstrate that a Credit Event has occurred.

The Reference Obligation

To clarify things further trades include a Reference Obligation. Normally this would be a senior unsecured bond issued by the Reference Entity. The Reference Obligation does not need to have a maturity equal to the CDS; frequently the reference asset has a maturity that is a little longer.

The Reference Obligation serves the purpose of defining the seniority of debt on which a credit event can be observed. It also determines the seniority of the debt that can be delivered should there be a credit event.

Settlement after a credit event

Depending on the documentation, credit default swaps can be physically settled or cash settled.

With physical settlement the protection buyer delivers actual securities, (these must be Deliverable Obligations of the Reference Entity), to the protection seller.

The seller then pays the buyer a sum of money equal to the notional or effective amount of the transaction, (par).

There will however be a number of restrictions related to the maturity and debt seniority. (Most CDS require senior unsecured debt as the deliverable).

Nevertheless the protection buyer will deliver the cheapest asset that is available for delivery and is in this sense long a delivery option.

Once the seller receives the asset they have a choice. They can sell it at the prevailing market price or alternatively participate in any debt workout.

With cash settlement a dealer poll is taken. Dealers are asked the price at which the Reference Obligation is trading. An average price is then calculated, (this process may vary with the documentation, the dealer poll can be an average price on a particular day rather than an average over a number of days). The cash settlement amount is then calculated.

For example, suppose the average price is 40%; the amount paid by the protection seller to the protection buyer would be 100%-40% = 60%. On a trade of $10m this would be $6m. The protection buyer normally pays the seller the accrued premium on the CDS from the last payment date to the credit event date.

Cash settlement can have certain advantages. When the number of outstanding CDS trades exceeds the amount of deliverables cash settlement can help. It reduces the possibility that the price of the deliverable instrument can rise due to artificial supply and demand conditions.

It is absolutely essential to have CDS trades properly documented. This means that you need to take legal opinion on the contract you are entering into.

Credit default swaps are the building blocks

The credit default swap is therefore the basic credit product. It can be used to take on or hedge credit exposures. It can be used to facilitate more sophisticated trades. For example first to default swaps, where the credit protection seller receives a premium for selling protection on a basket of credits. If any one of these experiences a credit event the swap is triggered. But the potential loss for the seller is limited. If a credit event occurs in the basket the swap terminates. The seller is not at risk to further credit events from the entities in the basket at a later date.

Credit linked notes and synthetic collateralised debt obligations also make use of CDS. These structured products use CDS to transfer credit exposures. With credit linked notes the CDS is used to add additional credit risk to a traditional medium term note issue. With debt obligations CDS are used in order to obtain credit exposure that is then subject to the credit tranching process.

First Published by Barbican Consulting Limited 2006