Credit Default Swap What is it – good or bad?

26/03/2018

| 26-03-2018 | Lionel Pavey |

A decade ago it was one of the financial instruments that was identified as causing the financial crisis. It had been one of the most popular financial products before the crisis with the market turnover growing by more than 50 times over a period of 7 years. It started out as a simple financial instrument to aid bond holders in obtaining protection from the risk of default. So what is a Credit Default Swap (CDS) and where did it all go wrong?

The buyer of a CDS pays regular premiums to the seller of the CDS – expressed in basis points. These payments are normally quarterly in arrears and the total value of the payment is dependent on the nominal value of the contract. This nominal value relates to the par value of the underlying bonds – if you hold bonds with a par value of EUR 5 million and wanted to buy protection for the full amount, then the CDS contract would be for EUR 5 million.

The seller of a CDS would receive these regular payments and would only pay out if the bond issuer defaulted. At the time of a credit event (default), the CDS seller would assume ownership of the bonds and pay the CDS buyer their par value. It can be likened to comprehensive insurance that we buy for our cars – we pay an annual premium and the insurance company covers us for the costs of any damage to the vehicle in the event of an accident.

What is a credit event?

The definitions of a credit event are set out in the contract and defined by referencing terms agreed by the International Swaps and Derivatives Association (ISDA). The major credit events, in European contracts, are bankruptcy, failure to pay on its debt obligations, and restructuring.

A contract will contain standard terms and conditions –

  • effective start date
  • scheduled termination date
  • the agreed price
  • payment dates
  • the reference entity (normally a bond issuer)
  • the reference obligation (usually an unsubordinated bond)
  • substitute reference obligations (if the original was repaid earlier than the termination date of the contract)
  • calculation agent

As previously stated, when the CDS market started it was seen as a product to protect bond holders and, in the event of a default, the CDS buyer could deliver the agreed reference obligation and receive its par value. In 2005, the limitations of this system were first recognised; Delphi – a manufacturer of auto parts – defaulted. The par value of their outstanding bonds was USD 2 billion – the sum of CDS contracts was USD 20 billion. As original bonds had to be tendered to validate the contract, a run ensued on the bonds and, whilst defaulting, the bond price went up!

This led to the next phase – cash settlement. Here, in the event of default, the CDS seller paid to the CDS buyer the difference between the par value and the market price – facilitated by an auction process to determine the fair market value.

However, an unintended consequence was the discovery and creation of different trading strategies that had not be envisaged when the CDS was designed. Before the introduction of CDS contracts, if you were bearish on a company you would need to short-sell their bonds. This is a sensitive process as the short position needs to be covered via bond lending to maintain the settlement position. With CDS it now became possible to purchase protection on a specific entity at a relatively cheap price – the CDS premium. It was therefore possible to replicate a physical short position with a derivative position.

It also led to the creation of “synthetic” instruments – synthetic CDS’s and CDO’s (Collateralized Debt Obligations). The sum of actual tradeable financial instruments were limited by their issue – synthetic products allowed banks to create products to meet the demand from clients to gain exposure to entities. It was a this stage that the market truly grew – it was possible to replicate any exposure that the client desired. When the financial crisis hit, all the “over the counter” derivatives compounded the problems. No one knew what the potential exposure of their counterparties was. These counterparties could have easily sold CDS contracts that could have a potential exposure to the par value of the underlying reference entities of bonds, CDO’s etc.

Is there a future?

CDS are useful financial products – most of the trades now take place on exchanges. However, the genie is not yet back in the bottle. There are now lawsuits – initiated by hedge funds – claiming that defaults are now being prearranged (Hovnanian Enterprises Inc.). The main problem is still who holds the potential risk and for how much. The essence of the product is viable and the original demand is still there. But, as with many financial products, as soon as they become commoditised, market turnover far exceeds the actual underlying market.

Lionel PaveyLionel Pavey – Cash Management and Treasury Specialist

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