Credit default swap
Encyclopedia
A credit default swap (CDS) is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default
. Generally, the agreement is that in the event of default the buyer of the CDS receives money (usually the face value
of the loan), and the seller of the CDS receives the defaulted loan (and with it the right to recover the loan at some later time).
However, there is a significant difference between a traditional insurance policy and a CDS. Anyone can purchase a CDS, even buyers who do not hold the loan instrument and may have no direct insurable interest
in the loan. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.These are called "naked" CDS, and in fact are a "bet" on default. The European Parliament has approved a ban on this kind of CDS, effective starting 1st December 2011.
Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010.
Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA)
, although some are tailored to meet specific needs. CDSs have many variations. In addition to the basic, single-name swaps, there are basket
default swaps (BDSs), index CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset backed securities.
CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose a systemic risk
to the economy.
Credit default swaps and other derivatives are unusual--and potentially dangerous--in that they combine priority in bankruptcy with a lack of transparency. In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data) announced it would voluntarily give regulators greater access to its credit default swaps database.
A number of financial professionals, regulators, and the media have begun using credit default swap pricing as a gauge of the riskiness of corporate and sovereign borrowers, and U.S. Courts may soon be following suit.
of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction.
A default is often referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower's credit rating
. Most CDSs are in the $10–$20 million range with maturities between one and 10 years. Five years is the most typical maturity.
A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to credit insurance, although CDS are not subject to regulations governing traditional insurance. Also, investors can buy and sell protection without owning debt of the reference entity. These “naked credit default swaps” allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity. Naked CDS constitute most of the market in CDS. In addition, CDSs can also be used in capital structure arbitrage
.
A "credit default swap" (CDS) is a credit derivative
contract between two counterparties
. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults
or experiences a similar credit event
. The CDS may refer to a specified loan or bond obligation of a “reference entity”, usually a corporation or government.
As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated. A default is referred to as a "credit event
" and includes such events as failure to pay, restructuring and bankruptcy. CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and acceleration.
If the investor actually owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge
. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp (see Uses).
If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur:
The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount
. For example, if the CDS spread of Risky Corp is 50 basis point
s, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or Risky Corp defaults. Payments are usually made on a quarterly basis, in arrears
.
All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be the best indicators of the likelihood of sellers of CDSs having to perform under these contracts.
However the most important difference between CDS and insurance is simply that an insurance contract provides an indemnity against the losses actually suffered by the policy holder, whereas the CDS provides an equal payout to all holders, calculated using an agreed, market-wide method.
There are also important differences in the approaches used to pricing. The cost of insurance is based on actuarial analysis
. CDSs are derivatives whose cost is determined using financial models and by arbitrage relationships with other credit market instruments such as loans and bonds from the same 'Reference Entity' the CDS contract refers to.
Further, to cancel the insurance contract the buyer can simply stop paying premium whereas in case of CDS the protection buyer may need to unwind the contract, which might result in a profit or loss situation.
Insurance contracts require the disclosure of all known risks involved. CDSs have no such requirement. Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to guarantee payment of claims.
In the future, in the event that regulatory reforms require that CDS be traded and settled via a central exchange/clearing house
, such as ICE TCC, there will no longer be 'counterparty risk', as the risk of the counterparty will be held with the central exchange/clearing house.
As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk
. If one or both parties to a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral
. The required collateral is agreed on by the parties when the CDS is first issued. This margin
amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating
of one of the parties changes. Many CDS contracts even require to pay an upfront at the beginning (also referred to as "initial margin").
Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk. A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives.
According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for virtually all CDS contracts outstanding in the marketplace."
The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S commercial banks and trust companies.
, hedging
and arbitrage
.
, that combines a CDS with a cash bond and an interest-rate swap.
Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on a company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company's creditworthiness might improve. The investor selling the CDS is viewed as being “long
” on the CDS and the credit, as if the investor owned the bond. In contrast, the investor who bought protection is “short” on the CDS and the underlying credit.
Credit default swaps opened up important new avenues to speculators. Investors could go long on a bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of default
. Shorting a bond faced difficult practical problems, such that shorting was often not feasible; CDS made shorting credit possible and popular. Because the speculator in either case does not own the bond, its position is said to be a synthetic long or short position.
For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys $10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference entity, at a spread of 500 basis points (=5%) per annum.
Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to realise its gains or losses. For example:
Transactions such as these do not even have to be entered into over the long-term. If Risky Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts.
Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS. CDOs are viewed as complex and opaque financial instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is the subject of the civil suit for fraud brought by the SEC against Goldman Sachs in April 2010. Abacus is a synthetic CDO consisting of credit default swaps referencing a variety of mortgage backed securities.
Critics assert that naked CDS should be banned, comparing them to buying fire insurance on your neighbor’s house, which creates a huge incentive for arson. Analogizing to the concept of insurable interest
, critics say you should not be able to buy a CDS—insurance against default—when you do not own the bond. Short selling is also viewed as gambling and the CDS market as a casino.
Another concern is the size of CDS market. Because naked credit default swaps are synthetic, there is no limit to how many can be sold. The gross amount of CDS far exceeds all “real” corporate bonds and loans outstanding. As a result, the risk of default is magnified leading to concerns about systemic risk.
Financier George Soros
called for an outright ban on naked credit default swaps, viewing them as “toxic” and allowing speculators to bet against and “bear raid” companies or countries. His concerns were echoed by several European politicians who, during the Greek Financial Crisis, accused naked CDS buyers of making the crisis worse.
Despite these concerns, Secretary of Treasury Geithner and Commodity Futures Trading Commission
Chairman Gensler are not in favor of an outright ban of naked credit default swaps. They prefer greater transparency and better capitalization requirements. These officials think that naked CDS have a place in the market.
Proponents of naked credit default swaps say that short selling in various forms, whether credit default swaps, options or futures, has the beneficial effect of increasing liquidity in the marketplace. That benefits hedging activities. Without speculators buying and selling naked CDS, banks wanting to hedge might not find a ready seller of protection. Speculators also create a more competitive marketplace, keeping prices down for hedgers. A robust market in credit default swaps can also serve as a barometer to regulators and investors about the credit health of a company or country.
Despite assertions that speculators are making the Greek crisis worse, Germany's market regulator BaFin found no proof supporting the claim. Some suggest that without credit default swaps, Greece’s borrowing costs would be higher. As of November 2011, the Greek bonds have a bond yield of 28%.
A bill in the U.S. Congress proposed giving a public authority the power to limit the use of CDS other than for hedging purposes, but the bill did not become law.
There are other ways to eliminate or reduce the risk of default. The bank could sell (that is, assign) the loan outright or bring in other banks as participants
. However, these options may not meet the bank’s needs. Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants.
If both the borrower and lender are well-known and the market (or even worse, the news media) learns that the bank is selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which could severely damage the banker-client relationship. In addition, the bank simply may not want to sell or share the potential profits from the loan. By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its portfolio. The downside to this hedge is that without default risk, a bank may have no motivation to actively monitor the loan and the counterparty has no relationship to the borrower.
Another kind of hedge is against concentration risk. A bank’s risk management team may advise that the bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this risk by buying a CDS. Because the borrower—the reference entity—is not a party to a credit default swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio or customer relations. Similarly, a bank selling a CDS can diversify its portfolio by gaining exposure to an industry in which the selling bank has no customer base.
A bank buying protection can also use a CDS to free regulatory capital. By offloading a particular credit risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8% of the total loan under Basel I
). This frees resources the bank can use to make other loans to the same key customer or to other borrowers.
Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy a CDS as a hedge for similar reasons.
Pension fund example: A pension fund owns five-year bonds issued by Risky Corp with par value of $10 million. To manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount
of $10 million. The CDS trades at 200 basis point
s (200 basis points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of $10 million ($200,000) per annum in quarterly installments of $50,000 to Derivative Bank.
In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables.
Although credit default swaps have been highly criticized for their role in the recent financial crisis, most observers conclude that using credit default swaps as a hedging device has a useful purpose.
strategy that utilizes CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall.
Techniques reliant on this are known as capital structure
arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i.e., mis-pricings between a company's debt and equity. An arbitrageur attempts to exploit the spread between a company's CDS and its equity in certain situations.
For example, if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection) while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity.
An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a Leveraged buyout
(LBO). Frequently this leads to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying a premium.
Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical reasons such as:
The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero. Basis trades can aim to exploit any differences to make risk-free profit.
in 1991. J.P. Morgan & Co.
is widely credited with creating the modern credit default swap in 1994. In that instance, J.P. Morgan had extended a $4.8 billion credit line to Exxon
, which faced the threat of $5 billion in punitive damages
for the Exxon Valdez oil spill
. A team of J.P. Morgan bankers led by Blythe Masters
then sold the credit risk from the credit line to the European Bank of Reconstruction and Development in order to cut the reserves that J.P. Morgan was required to hold against Exxon's default, thus improving its own balance sheet.
In 1997, JPMorgan developed a proprietary product called BISTRO (Broad Index Securitized Trust Offering) that used CDS to clean up a bank’s balance sheet. The advantage of BISTRO was that it used securitization to split up the credit risk into little pieces that smaller investors found more digestible, since most investors lacked EBRD's capability to accept $4.8 billion in credit risk all at once. BISTRO was the first example of what later became known as synthetic collateralized debt obligations (CDOs).
Mindful of the concentration of default risk as one of the causes of the S&L crisis
, regulators initially found CDS's ability to disperse default risk attractive.
In 2000, credit default swaps became largely exempt from regulation by both the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission
(CFTC). The Commodity Futures Modernization Act of 2000
, which was also responsible for the Enron loophole
, specifically stated that CDSs are neither futures nor securities and so are outside the remit of the SEC and CFTC.
The high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge funds saw trading opportunities in credit default swaps. By 2002, investors as speculators, rather than banks as hedgers, dominated the market.
National banks in the USA used credit default swaps as early as 1996. In that year, the Office of the Comptroller of the Currency measured the size of the market as tens of billions of dollars. Six years later, by year-end 2002, the outstanding amount was over $2 trillion.
Although speculators fueled the exponential growth, other factors also played a part. An extended market could not emerge until 1999, when ISDA standardized the documentation for credit default swaps. Also, the 1997 Asian Financial Crisis spurred a market for CDS in emerging market sovereign debt. In addition, in 2004, index trading began on a large scale and grew rapidly.
The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003. By the end of 2007, the CDS market had a notional value of $62.2 trillion. But notional amount fell during 2008 as a result of dealer "portfolio compression" efforts (replacing offsetting redundant contracts), and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion.
Explosive growth was not without operational headaches. On September 15, 2005, the New York Fed summoned 14 banks to it offices. Billions of dollars of CDS were traded daily but the record keeping was more than two weeks behind. This created severe risk management issues, as counterparties were in legal and financial limbo. U.K. authorities expressed the same concerns.
Since default is a relatively rare occurrence (historically around 0.2% of investment grade companies default in any one year), in most CDS contracts the only payments are the premium payments from buyer to seller. Thus, although the above figures for outstanding notionals are very large, in the absence of default the net cash flows are only a small fraction of this total: for a 100 bp = 1% spread, the annual cash flows are only 1% of the notional amount.
.
In the days and weeks leading up to Bear's collapse, the bank's CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital, which eventually led to its forced sale to JP Morgan in March. An alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear's collapse; i.e., investors saw that Bear was in trouble, and sought to hedge any naked exposure to the bank, or speculate on its collapse.
In September, the bankruptcy of Lehman Brothers
caused a total close to $400 billion to become payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed hands was around $7.2 billion. This difference is due to the process of 'netting'. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral, so that their losses and gains after big events offset each other.
Also in September American International Group (AIG
) required a federal bailout because it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses over $100 billion. The CDS on Lehman were settled smoothly, as was largely the case for the other 11 credit events occurring in 2008 that triggered payouts. And while it is arguable that other incidents would have been as bad or worse if less efficient instruments than CDS had been used for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risk involved in CDS transactions.
In 2008 there was no centralized exchange
or clearing house
for CDS transactions; they were all done over the counter
(OTC). This led to recent calls for the market to open up in terms of transparency and regulation. In November, DTCC, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total market, announced that it will release market data on the outstanding notional of CDS trades on a weekly basis. The data can be accessed on the DTCC's website here:
The U.S. Securities and Exchange Commission granted an exemption for IntercontinentalExchange
to begin guaranteeing credit-default swaps.
The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. Its larger competitor, CME Group Inc., hasn’t received an SEC exemption, and agency spokesman John Nester said he didn’t know when a decision would be made.
managing director Athanassios Diplas "the industry pushed through 10 years worth of changes in just a few months".
By late 2008 processes had been introduced allowing CDSs that offset each other to be cancelled. Along with termination of contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion.
The Bank for International Settlements estimates that outstanding derivatives total $592 trillion. U.S. and European regulators are developing separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, administered by International Swaps and Derivatives Association (ISDA). Two of the key changes are:
1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face.
2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the payout should be is unclear.
Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York, stated
In the U.S., central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group.
In Europe, CDS Index clearing was launched by ICE's European subsidiary ICE Clear Europe on July 31. It launched Single Name clearing in Dec 2009. By the end of 2009, it had cleared CDS contracts worth EUR 885 billion reducing the open interest down to EUR 75 billion
By the end of 2009, banks had reclaimed much of their market share; hedge funds had largely retreated from the market after the crises. According to an estimate by the Banque de France
, by late 2009 the bank JP Morgan alone now had about 30% of the global CDS market.
Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG, received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s cash on hand and a 50-50 profit-sharing agreement with Intercontinental on the revenue generated from processing the swaps.
SEC spokesperson John Nestor stated
Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan. 30, no swaps had been cleared by the NYSE’s London- based derivatives exchange, according to NYSE Chief Executive Officer Duncan Niederauer.
A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators to view traders’ positions and prices.
. The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond
or government bond
. The period over which default protection extends is defined by the contract effective date and scheduled termination date.
The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations (for example necessary if the original reference obligation was a loan that is repaid before the expiry of the contract), and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent.
It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.
CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not.
The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco
's restructuring in 2000 led to the credit event's removal from North American high yield trades.
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A
), that it be of a standard currency and that it not be subject to some contingency before becoming due.
The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates) falling on March 20, June 20, September 20, and December 20. Due to the proximity to the IMM dates
, which fall on the third Wednesday of these months, these CDS maturity dates are also referred to as "IMM dates".
The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations. (This is because many parties made CDS contracts for speculative purposes, without actually owning any debt that they wanted to insure against default.) For example, at the time it filed for bankruptcy on September 14, 2008, Lehman Brothers had approximately $155 billion of outstanding debt but around $400 billion notional value of CDS contracts had been written that referenced this debt. Clearly not all of these contracts could be physically settled, since there was not enough outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for cash settled CDS trades. The trade confirmation produced when a CDS is traded states whether the contract is to be physically or cash settled.
is held following the publication of the initial mid-point of the dealer markets and what is the net open interest to deliver or be delivered actual bonds or loans. The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled. According to the International Swaps and Derivatives Association
(ISDA), who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman Brothers
and Washington Mutual
.
Below is a list of the auctions that have been held since 2005.
The second model, proposed by Darrell Duffie
, but also by John Hull and White, uses a no-arbitrage approach.
(risk-adjusted NPV) model used in drug development
:
If default
events never occurred the price of a CDS would simply be the sum of the discounted
premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. For the purpose of explanation we can imagine the case of a one year CDS with effective date
with four quarterly premium payments occurring at times 
, 
, 
, and 
. If the nominal for the CDS is 
and the issue premium is 
then the size of the quarterly premium payments is 
. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end:
To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value
of the five payoffs multiplied by their probability of occurring.
This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in which case it ends with a payment of
shown in red, where 
is the recovery rate, or it survives without a default being triggered, in which case a premium payment of 
is made, shown in blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.
The probability of surviving over the interval
to 
without a default payment is 
and the probability of a default being triggered is 
. The calculation of present value, given discount factor of 
to 
is then
The probabilities
, 
, 
, 
can be calculated using the credit spread
curve. The probability of no default occurring over a time period from
to 
decays exponentially with a time-constant determined by the credit spread, or mathematically 
where 
is the credit spread
zero curve at time
. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time.
To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give
Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a CDS contract should trade at 30. However there are sometimes technical reasons why this will not be the case, and this may or may not present an arbitrage opportunity for the canny investor. The difference between the theoretical model and the actual price of a credit default swap is known as the basis.
.
In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default.
Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the 2009 General Motors Chapter 11 reorganization
, because bondholders would benefit from the credit event of a GM bankruptcy due to their holding of CDSs. Critics speculate that these creditors were incentivized into pushing for the company to enter bankruptcy protection. Due to a lack of transparency, there was no way to find out who the protection buyers and protection writers were, and they were subsequently left out of the negotiation process.
It was also reported after Lehman's bankruptcy that the $400 billion notional of CDS protection which had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers (given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts could lead to further bankruptcies of firms without enough cash to settle their contracts. However, industry estimates after the auction suggested that net cashflows would only be in the region of $7 billion.
This is because many parties held offsetting positions; for example if a bank writes CDS protection on a company it is likely to then enter an offsetting transaction by buying protection on the same company in order to hedge its risk. Furthermore, CDS deals are marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, meaning that the net cashflows on the days after the auction are likely to have been even lower.
Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis, but that CDS contracts have been acting to distribute risk just as was intended, and that it is not CDSs themselves that need further regulation, but the parties who trade them.
Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett
famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway
's annual report to shareholders in 2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."
To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on one's counterparty. The positions are marked-to-market daily and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money does not always change hands due to the offset of gains and losses by those who had both bought and sold protection. Depository Trust & Clearing Corporation, the clearinghouse for the majority of trades in the US over-the-counter market, stated in October 2008 that once offsetting trades were considered, only an estimated $6 billion would change hands on October 21, during the settlement of the CDS contracts issued on Lehman Brothers' debt, which amounted to somewhere between $150 to $360 billion.
Despite Buffett's criticism on derivatives, in October 2008 Berkshire Hathaway revealed to regulators that it has entered into at least $4.85 billion in derivative transactions. Buffett stated in his 2008 letter to shareholders that Berkshire Hathaway has no counterparty risk in its derivative dealings because Berkshire require counterparties to make payments when contracts are inititated, so that Berkshire always holds the money. Berkshire Hathaway was a large owner of Moody's stock during the period that it was one of two primary rating agencies for subprime CDOs, a form of mortgage security derivative dependant on the use of credit default swaps.
The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the monolines. In 2009 one of the monolines, MBIA, sued Merrill Lynch
, claiming that Merill had misrepresented some of its CDOs to MBIA in order to persuade MBIA to write CDS protection for those CDOs.
, risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.
For example, imagine if a hypothetical mutual fund
had bought some Washington Mutual
corporate bonds in 2005 and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After Lehman's default, this protection was no longer active, and Washington Mutual's sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. There was also fear that Lehman Brothers and AIG's inability to pay out on CDS contracts would lead to the unraveling of complex interlinked chain of CDS transactions between financial institutions. So far this does not appear to have happened, although some commentators have noted that because the total CDS exposure of a bank is not public knowledge, the fear that one could face large losses or possibly even default themselves was a contributing factor to the massive decrease in lending liquidity during September/October 2008.
Chains of CDS transactions can arise from a practice known as "netting". Here, company B may buy a CDS from company A with a certain annual premium, say 2%. If the condition of the reference company worsens, the risk premium rises, so company B can sell a CDS to company C with a premium of say, 5%, and pocket the 3% difference. However, if the reference company defaults, company B might not have the assets on hand to make good on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to company C.
The problem lies if one of the companies in the chain fails, creating a "domino effect
" of losses. For example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company. Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A; it is only doing business with company B.
As described above, the establishment of a central exchange or clearing house for CDS trades would help to solve the "domino effect" problem, since it would mean that all trades faced a central counterparty guaranteed by a consortium of dealers.
s or options
for tax purposes, but this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).
If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income. If a payment is a termination payment, its tax treatment is even more uncertain. In 2004, the Internal Revenue Service
announced that it was studying the characterization of credit default swaps in response to taxpayer confusion, but it has not yet issued any guidance on their characterization. A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States.
The accounting treatment of Credit Default Swaps used for hedging may not parallel the economic effects and instead, increase volatility. For example, GAAP generally require that Credit Default Swaps be reported on a mark to market
basis. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce considerable volatility into the income statement
and balance sheet
as the CDS changes value over its life due to market conditions and due to the tendency for shorter dated CDS to sell at lower prices than longer dated CDS. One can try to account for the CDS as a hedge under FASB 133 but in practice that can prove very difficult unless the risky asset owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular CDS that was bought.
.
Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed the cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name.
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
. Generally, the agreement is that in the event of default the buyer of the CDS receives money (usually the face value
Face value
The Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...
of the loan), and the seller of the CDS receives the defaulted loan (and with it the right to recover the loan at some later time).
However, there is a significant difference between a traditional insurance policy and a CDS. Anyone can purchase a CDS, even buyers who do not hold the loan instrument and may have no direct insurable interest
Insurable interest
Insurable interest exists when an insured person derives a financial or other kind of benefit from the continuous existence of the insured object...
in the loan. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.These are called "naked" CDS, and in fact are a "bet" on default. The European Parliament has approved a ban on this kind of CDS, effective starting 1st December 2011.
Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010.
Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA)
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
, although some are tailored to meet specific needs. CDSs have many variations. In addition to the basic, single-name swaps, there are basket
Basket (finance)
A basket is an economic term for a group of several securities created for the purpose of simultaneous buying or selling. Baskets are frequently used for program trading.Certain specific products can be seen as specialized "baskets"....
default swaps (BDSs), index CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset backed securities.
CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose a systemic risk
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
to the economy.
Credit default swaps and other derivatives are unusual--and potentially dangerous--in that they combine priority in bankruptcy with a lack of transparency. In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data) announced it would voluntarily give regulators greater access to its credit default swaps database.
A number of financial professionals, regulators, and the media have begun using credit default swap pricing as a gauge of the riskiness of corporate and sovereign borrowers, and U.S. Courts may soon be following suit.
Description
A CDS is linked to a "reference entity" or "reference obligor", usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the "spread" charged by the seller to insure against a credit event. If the reference entity defaults, the protection seller pays the buyer the par valuePar value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction.
A default is often referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower's credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
. Most CDSs are in the $10–$20 million range with maturities between one and 10 years. Five years is the most typical maturity.
A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to credit insurance, although CDS are not subject to regulations governing traditional insurance. Also, investors can buy and sell protection without owning debt of the reference entity. These “naked credit default swaps” allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity. Naked CDS constitute most of the market in CDS. In addition, CDSs can also be used in capital structure arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
.
A "credit default swap" (CDS) is a credit derivative
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
contract between two counterparties
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
or experiences a similar credit event
Credit event
A credit event is the financial term used to describe either:* A general default event related to a legal entity's previously agreed financial obligation. In this case, a legal entity fails to meet its obligation on any significant financial transaction...
. The CDS may refer to a specified loan or bond obligation of a “reference entity”, usually a corporation or government.
As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated. A default is referred to as a "credit event
Credit event
A credit event is the financial term used to describe either:* A general default event related to a legal entity's previously agreed financial obligation. In this case, a legal entity fails to meet its obligation on any significant financial transaction...
" and includes such events as failure to pay, restructuring and bankruptcy. CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and acceleration.
If the investor actually owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp (see Uses).
If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur:
- the investor delivers a defaulted asset to Bank for payment of the par valuePar valuePar value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
, which is known as physical settlement; - AAA-Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if Risky Corp defaults there is usually some recovery, i.e., not all the investor's money is lost), which is known as cash settlement.
The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
. For example, if the CDS spread of Risky Corp is 50 basis point
Basis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...
s, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or Risky Corp defaults. Payments are usually made on a quarterly basis, in arrears
Arrears
Arrears is a legal term for the part of a debt that is overdue after missing one or more required payments. The amount of the arrears is the amount accrued from the date on which the first missed payment was due...
.
All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be the best indicators of the likelihood of sellers of CDSs having to perform under these contracts.
Not insurance
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:- The buyer of a CDS does not need to own the underlying securitySecurity (finance)A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
or other form of credit exposureCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
; in fact the buyer does not even have to suffer a loss from the default event. In contrast, to purchase insurance, the insured is generally expected to have an insurable interestInsurable interestInsurable interest exists when an insured person derives a financial or other kind of benefit from the continuous existence of the insured object...
such as owning a debt obligation; - the seller doesn't have to be a regulated entity;
- the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements;
- insurers manage risk primarily by setting loss reservesLoss ReservingLoss reserving or Outstanding claims reserves refers to the calculation of the required reserves for a tranche of general insurance business....
based on the Law of large numbersLaw of large numbersIn probability theory, the law of large numbers is a theorem that describes the result of performing the same experiment a large number of times...
, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets; - in the United States CDS contracts are generally subject to mark-to-market accounting, introducing income statementIncome statementIncome statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
and balance sheetBalance sheetIn financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
volatilityVolatility (finance)In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
that would not be present in an insurance contract; - Hedge accountingHedge AccountingHedge accounting is an accountancy practice.-Why is hedge accounting necessary?:Many financial institutions and corporate businesses use derivative financial instruments to hedge their exposure to different risks .Accounting for derivative financial instruments under International Accounting...
may not be available under US Generally Accepted Accounting PrinciplesGenerally Accepted Accounting PrinciplesGenerally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
(GAAP) unless the requirements of FAS 133 are met. In practice this rarely happens.
However the most important difference between CDS and insurance is simply that an insurance contract provides an indemnity against the losses actually suffered by the policy holder, whereas the CDS provides an equal payout to all holders, calculated using an agreed, market-wide method.
There are also important differences in the approaches used to pricing. The cost of insurance is based on actuarial analysis
Actuarial science
Actuarial science is the discipline that applies mathematical and statistical methods to assess risk in the insurance and finance industries. Actuaries are professionals who are qualified in this field through education and experience...
. CDSs are derivatives whose cost is determined using financial models and by arbitrage relationships with other credit market instruments such as loans and bonds from the same 'Reference Entity' the CDS contract refers to.
Further, to cancel the insurance contract the buyer can simply stop paying premium whereas in case of CDS the protection buyer may need to unwind the contract, which might result in a profit or loss situation.
Insurance contracts require the disclosure of all known risks involved. CDSs have no such requirement. Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to guarantee payment of claims.
Risk
When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk:- The buyer takes the risk that the seller may default. If AAA-Bank and Risky Corp. default simultaneously ("double default"), the buyer loses its protection against default by the reference entity. If AAA-Bank defaults but Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost.
- The seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying offsetting protection from another party — that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the seller.
In the future, in the event that regulatory reforms require that CDS be traded and settled via a central exchange/clearing house
Clearing house (finance)
A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
, such as ICE TCC, there will no longer be 'counterparty risk', as the risk of the counterparty will be held with the central exchange/clearing house.
As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
. If one or both parties to a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. The required collateral is agreed on by the parties when the CDS is first issued. This margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
of one of the parties changes. Many CDS contracts even require to pay an upfront at the beginning (also referred to as "initial margin").
Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk. A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives.
Sources of market data
Data about the credit default swaps market is available from three main sources. Data on an annual and semiannual basis is available from the International Swaps and Derivatives Association (ISDA) since 2001 and from the Bank for International Settlements (BIS) since 2004. The Depository Trust & Clearing Corporation (DTCC), through its global repository Trade Information Warehouse (TIW), provides weekly data but publicly available information goes back only one year. The numbers provided by each source do not always match because each provider uses different sampling methods.According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for virtually all CDS contracts outstanding in the marketplace."
The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S commercial banks and trust companies.
Uses
Credit default swaps can be used by investors for speculationSpeculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
, hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
and arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
.
Speculation
Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices such as the North American CDX index or the European iTraxx index. An investor might believe that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit from that view by entering into a trade, known as a basis tradeBasis trading
Basis trading is a trading strategy usually consisting of the purchase of a particular security and the sale of a similar security ....
, that combines a CDS with a cash bond and an interest-rate swap.
Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on a company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company's creditworthiness might improve. The investor selling the CDS is viewed as being “long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
” on the CDS and the credit, as if the investor owned the bond. In contrast, the investor who bought protection is “short” on the CDS and the underlying credit.
Credit default swaps opened up important new avenues to speculators. Investors could go long on a bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of default
Event of default
Event of default is a term used in commercial loan documentation. It refers to the occurrence of an event which allows the lender to demand repayment of the loan in advance of its normal due date...
. Shorting a bond faced difficult practical problems, such that shorting was often not feasible; CDS made shorting credit possible and popular. Because the speculator in either case does not own the bond, its position is said to be a synthetic long or short position.
For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys $10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference entity, at a spread of 500 basis points (=5%) per annum.
- If Risky Corp does indeed default after, say, one year, then the hedge fund will have paid $500,000 to AAA-Bank, but then receives $10 million (assuming zero recovery rate, and that AAA-Bank has the liquidity to cover the loss), thereby making a profit. AAA-Bank, and its investors, will incur a $9.5 million loss minus recovery unless the bank has somehow offset the position before the default.
- However, if Risky Corp does not default, then the CDS contract runs for two years, and the hedge fund ends up paying $1 million, without any return, thereby making a loss. AAA-Bank, by selling protection, has made $1 million without any upfront investment.
Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to realise its gains or losses. For example:
- After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this higher rate. Therefore, over the two years the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but receives 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000.
- In another scenario, after one year the market now considers Risky much less likely to default, so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge fund may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this lower spread. Therefore over the two years the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but receives 1 * 2.5% * $10 million = $250,000, giving a total loss of $750,000. This loss is smaller than the $1 million loss that would have occurred if the second transaction had not been entered into.
Transactions such as these do not even have to be entered into over the long-term. If Risky Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts.
Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS. CDOs are viewed as complex and opaque financial instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is the subject of the civil suit for fraud brought by the SEC against Goldman Sachs in April 2010. Abacus is a synthetic CDO consisting of credit default swaps referencing a variety of mortgage backed securities.
Naked credit default swaps
In the examples above, the hedge fund did not own debt of Risky Corp. A CDS in which the buyer does not own the underlying debt is referred to as a naked credit default swap, estimated to be up to 80% of the credit default swap market. There is currently a debate in the United States and Europe about whether speculative uses of credit default swaps should be banned. Legislation is under consideration by Congress as part of financial reform.Critics assert that naked CDS should be banned, comparing them to buying fire insurance on your neighbor’s house, which creates a huge incentive for arson. Analogizing to the concept of insurable interest
Insurable interest
Insurable interest exists when an insured person derives a financial or other kind of benefit from the continuous existence of the insured object...
, critics say you should not be able to buy a CDS—insurance against default—when you do not own the bond. Short selling is also viewed as gambling and the CDS market as a casino.
Another concern is the size of CDS market. Because naked credit default swaps are synthetic, there is no limit to how many can be sold. The gross amount of CDS far exceeds all “real” corporate bonds and loans outstanding. As a result, the risk of default is magnified leading to concerns about systemic risk.
Financier George Soros
George Soros
George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...
called for an outright ban on naked credit default swaps, viewing them as “toxic” and allowing speculators to bet against and “bear raid” companies or countries. His concerns were echoed by several European politicians who, during the Greek Financial Crisis, accused naked CDS buyers of making the crisis worse.
Despite these concerns, Secretary of Treasury Geithner and Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
Chairman Gensler are not in favor of an outright ban of naked credit default swaps. They prefer greater transparency and better capitalization requirements. These officials think that naked CDS have a place in the market.
Proponents of naked credit default swaps say that short selling in various forms, whether credit default swaps, options or futures, has the beneficial effect of increasing liquidity in the marketplace. That benefits hedging activities. Without speculators buying and selling naked CDS, banks wanting to hedge might not find a ready seller of protection. Speculators also create a more competitive marketplace, keeping prices down for hedgers. A robust market in credit default swaps can also serve as a barometer to regulators and investors about the credit health of a company or country.
Despite assertions that speculators are making the Greek crisis worse, Germany's market regulator BaFin found no proof supporting the claim. Some suggest that without credit default swaps, Greece’s borrowing costs would be higher. As of November 2011, the Greek bonds have a bond yield of 28%.
A bill in the U.S. Congress proposed giving a public authority the power to limit the use of CDS other than for hedging purposes, but the bill did not become law.
Hedging
Credit default swaps are often used to manage the risk of default that arises from holding debt. A bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection. If the loan goes into default, the proceeds from the CDS contract cancel out the losses on the underlying debt.There are other ways to eliminate or reduce the risk of default. The bank could sell (that is, assign) the loan outright or bring in other banks as participants
Participation loan
Participation loans are loans made by multiple lenders to a single borrower. Several banks, for example, might chip in to fund one extremely large loan, with one of the banks taking the role of the “lead bank.” This lending institution then recruits other banks to participate and share the risks...
. However, these options may not meet the bank’s needs. Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants.
If both the borrower and lender are well-known and the market (or even worse, the news media) learns that the bank is selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which could severely damage the banker-client relationship. In addition, the bank simply may not want to sell or share the potential profits from the loan. By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its portfolio. The downside to this hedge is that without default risk, a bank may have no motivation to actively monitor the loan and the counterparty has no relationship to the borrower.
Another kind of hedge is against concentration risk. A bank’s risk management team may advise that the bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this risk by buying a CDS. Because the borrower—the reference entity—is not a party to a credit default swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio or customer relations. Similarly, a bank selling a CDS can diversify its portfolio by gaining exposure to an industry in which the selling bank has no customer base.
A bank buying protection can also use a CDS to free regulatory capital. By offloading a particular credit risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8% of the total loan under Basel I
Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...
). This frees resources the bank can use to make other loans to the same key customer or to other borrowers.
Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy a CDS as a hedge for similar reasons.
Pension fund example: A pension fund owns five-year bonds issued by Risky Corp with par value of $10 million. To manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
of $10 million. The CDS trades at 200 basis point
Basis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...
s (200 basis points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of $10 million ($200,000) per annum in quarterly installments of $50,000 to Derivative Bank.
- If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million back after five years from Risky Corp. Though the protection payments totaling $1 million reduce investment returns for the pension fund, its risk of loss due to Risky Corp defaulting on the bond is eliminated.
- If Risky Corporation defaults on its debt three years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million minus recovery (either by physical or cash settlement — see Settlement below). The pension fund still loses the $600,000 it has paid over three years, but without the CDS contract it would have lost the entire $10 million minus recovery.
In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables.
Although credit default swaps have been highly criticized for their role in the recent financial crisis, most observers conclude that using credit default swaps as a hedging device has a useful purpose.
Arbitrage
Capital Structure Arbitrage is an example of an arbitrageArbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
strategy that utilizes CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall.
Techniques reliant on this are known as capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i.e., mis-pricings between a company's debt and equity. An arbitrageur attempts to exploit the spread between a company's CDS and its equity in certain situations.
For example, if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection) while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity.
An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a Leveraged buyout
Leveraged buyout
A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...
(LBO). Frequently this leads to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying a premium.
Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical reasons such as:
- Specific settlement differences
- Shortages in a particular underlying instrument
- Existence of buyers constrained from buying exotic derivatives.
The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero. Basis trades can aim to exploit any differences to make risk-free profit.
Conception
Forms of credit default swaps had been in existence from at least the early 1990s, with early trades carried out by Bankers TrustBankers Trust
Bankers Trust was an historic American banking organization. The bank merged with Alex. Brown & Sons before being acquired by Deutsche Bank in 1998.-History:A consortium of banks created Bankers Trust to perform trust company services for their clients....
in 1991. J.P. Morgan & Co.
J.P. Morgan & Co.
J.P. Morgan & Co. was a commercial and investment banking institution based in the United States founded by J. Pierpont Morgan and commonly known as the House of Morgan or simply Morgan. Today, J.P...
is widely credited with creating the modern credit default swap in 1994. In that instance, J.P. Morgan had extended a $4.8 billion credit line to Exxon
Exxon
Exxon is a chain of gas stations as well as a brand of motor fuel and related products by ExxonMobil. From 1972 to 1999, Exxon was the corporate name of the company previously known as Standard Oil Company of New Jersey or Jersey Standard....
, which faced the threat of $5 billion in punitive damages
Punitive damages
Punitive damages or exemplary damages are damages intended to reform or deter the defendant and others from engaging in conduct similar to that which formed the basis of the lawsuit...
for the Exxon Valdez oil spill
Exxon Valdez oil spill
The Exxon Valdez oil spill occurred in Prince William Sound, Alaska, on March 24, 1989, when the Exxon Valdez, an oil tanker bound for Long Beach, California, struck Prince William Sound's Bligh Reef and spilled of crude oil. It is considered to be one of the most devastating human-caused...
. A team of J.P. Morgan bankers led by Blythe Masters
Blythe Masters
Blythe Sally Jess Masters is an economist and current head of Global Commodities at J.P. Morgan Chase. From 2004-2007, she was Chief Financial Officer of J.P...
then sold the credit risk from the credit line to the European Bank of Reconstruction and Development in order to cut the reserves that J.P. Morgan was required to hold against Exxon's default, thus improving its own balance sheet.
In 1997, JPMorgan developed a proprietary product called BISTRO (Broad Index Securitized Trust Offering) that used CDS to clean up a bank’s balance sheet. The advantage of BISTRO was that it used securitization to split up the credit risk into little pieces that smaller investors found more digestible, since most investors lacked EBRD's capability to accept $4.8 billion in credit risk all at once. BISTRO was the first example of what later became known as synthetic collateralized debt obligations (CDOs).
Mindful of the concentration of default risk as one of the causes of the S&L crisis
Savings and Loan crisis
The savings and loan crisis of the 1980s and 1990s was the failure of about 747 out of the 3,234 savings and loan associations in the United States...
, regulators initially found CDS's ability to disperse default risk attractive.
In 2000, credit default swaps became largely exempt from regulation by both the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
(CFTC). The Commodity Futures Modernization Act of 2000
Commodity Futures Modernization Act of 2000
The Commodity Futures Modernization Act of 2000 is United States federal legislation that officially ensured the deregulation of financial products known as over-the-counter derivatives. It was signed into law on December 21, 2000 by President Bill Clinton...
, which was also responsible for the Enron loophole
Enron loophole
The "Enron loophole" exempts most over-the-counter energy trades and trading on electronic energy commodity markets from government regulation....
, specifically stated that CDSs are neither futures nor securities and so are outside the remit of the SEC and CFTC.
Market growth
At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in connection with its lending activities. Banks also saw an opportunity to free up regulatory capital. By march 1998, the global market for CDS was estimated atabout $300 billion, with JP Morgan alone accounting for about $50 billion of this.The high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge funds saw trading opportunities in credit default swaps. By 2002, investors as speculators, rather than banks as hedgers, dominated the market.
National banks in the USA used credit default swaps as early as 1996. In that year, the Office of the Comptroller of the Currency measured the size of the market as tens of billions of dollars. Six years later, by year-end 2002, the outstanding amount was over $2 trillion.
Although speculators fueled the exponential growth, other factors also played a part. An extended market could not emerge until 1999, when ISDA standardized the documentation for credit default swaps. Also, the 1997 Asian Financial Crisis spurred a market for CDS in emerging market sovereign debt. In addition, in 2004, index trading began on a large scale and grew rapidly.
The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003. By the end of 2007, the CDS market had a notional value of $62.2 trillion. But notional amount fell during 2008 as a result of dealer "portfolio compression" efforts (replacing offsetting redundant contracts), and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion.
Explosive growth was not without operational headaches. On September 15, 2005, the New York Fed summoned 14 banks to it offices. Billions of dollars of CDS were traded daily but the record keeping was more than two weeks behind. This created severe risk management issues, as counterparties were in legal and financial limbo. U.K. authorities expressed the same concerns.
Market as of 2008
Regulatory concerns over CDS
The market for Credit Default Swaps attracted considerable concern from regulators after a number of large scale incidents in 2008, starting with the collapse of Bear StearnsBear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
.
In the days and weeks leading up to Bear's collapse, the bank's CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital, which eventually led to its forced sale to JP Morgan in March. An alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear's collapse; i.e., investors saw that Bear was in trouble, and sought to hedge any naked exposure to the bank, or speculate on its collapse.
In September, the bankruptcy of Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
caused a total close to $400 billion to become payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed hands was around $7.2 billion. This difference is due to the process of 'netting'. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral, so that their losses and gains after big events offset each other.
Also in September American International Group (AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
) required a federal bailout because it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses over $100 billion. The CDS on Lehman were settled smoothly, as was largely the case for the other 11 credit events occurring in 2008 that triggered payouts. And while it is arguable that other incidents would have been as bad or worse if less efficient instruments than CDS had been used for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risk involved in CDS transactions.
In 2008 there was no centralized exchange
Exchange (organized market)
An exchange is a highly organized market where tradable securities, commodities, foreign exchange, futures, and options contracts are sold and bought.-Description:...
or clearing house
Clearing house (finance)
A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
for CDS transactions; they were all done over the counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC). This led to recent calls for the market to open up in terms of transparency and regulation. In November, DTCC, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total market, announced that it will release market data on the outstanding notional of CDS trades on a weekly basis. The data can be accessed on the DTCC's website here:
The U.S. Securities and Exchange Commission granted an exemption for IntercontinentalExchange
IntercontinentalExchange
IntercontinentalExchange, Inc., known as ICE, is an American financial company that operates Internet-based marketplaces which trade futures and over-the-counter energy and commodity contracts as well as derivative financial products...
to begin guaranteeing credit-default swaps.
The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. Its larger competitor, CME Group Inc., hasn’t received an SEC exemption, and agency spokesman John Nester said he didn’t know when a decision would be made.
Market as of 2009
The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from concerns over the instruments' safety after the events of the previous year. According to Deutsche BankDeutsche Bank
Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
managing director Athanassios Diplas "the industry pushed through 10 years worth of changes in just a few months".
By late 2008 processes had been introduced allowing CDSs that offset each other to be cancelled. Along with termination of contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion.
The Bank for International Settlements estimates that outstanding derivatives total $592 trillion. U.S. and European regulators are developing separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, administered by International Swaps and Derivatives Association (ISDA). Two of the key changes are:
1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face.
2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the payout should be is unclear.
Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York, stated
In the U.S., central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group.
In Europe, CDS Index clearing was launched by ICE's European subsidiary ICE Clear Europe on July 31. It launched Single Name clearing in Dec 2009. By the end of 2009, it had cleared CDS contracts worth EUR 885 billion reducing the open interest down to EUR 75 billion
By the end of 2009, banks had reclaimed much of their market share; hedge funds had largely retreated from the market after the crises. According to an estimate by the Banque de France
Banque de France
The Banque de France is the central bank of France; it is linked to the European Central Bank . Its main charge is to implement the interest rate policy of the European System of Central Banks...
, by late 2009 the bank JP Morgan alone now had about 30% of the global CDS market.
Government approvals relating to Intercontinental and its competitor CME
The SEC's approval for ICE's request to be exempted from rules that would prevent it clearing CDSs was the third government action granted to Intercontinental in one week. On March 3, its proposed acquisition of Clearing Corp., a Chicago clearinghouse owned by eight of the largest dealers in the credit-default swap market, was approved by the Federal Trade Commission and the Justice Department. On March 5, the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to begin clearing.Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG, received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s cash on hand and a 50-50 profit-sharing agreement with Intercontinental on the revenue generated from processing the swaps.
SEC spokesperson John Nestor stated
Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan. 30, no swaps had been cleared by the NYSE’s London- based derivatives exchange, according to NYSE Chief Executive Officer Duncan Niederauer.
Clearing house member requirements
Members of the Intercontinental clearinghouse will have to have a net worth of at least $5 billion and a credit rating of A or better to clear their credit-default swap trades. Intercontinental said in the statement today that all market participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long as they meet these requirements.A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators to view traders’ positions and prices.
Terms of a typical CDS contract
A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives AssociationInternational Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
. The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond
Corporate bond
A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
or government bond
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...
. The period over which default protection extends is defined by the contract effective date and scheduled termination date.
The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations (for example necessary if the original reference obligation was a loan that is repaid before the expiry of the contract), and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent.
It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.
CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not.
The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco
Conseco
Conseco , originally Security Life of Indiana, is a financial services organization based in Carmel, Indiana. Conseco's insurance subsidiaries provide life insurance, annuity and supplemental health insurance products to more than 4 million customers in the United States...
's restructuring in 2000 led to the credit event's removal from North American high yield trades.
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A
Rule 144A
Rule 144A. Securities Act of 1933, as amended provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private resales of minimum $500,000 units of restricted securities to QIBs , which generally are large institutional investors that own at least $100...
), that it be of a standard currency and that it not be subject to some contingency before becoming due.
The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates) falling on March 20, June 20, September 20, and December 20. Due to the proximity to the IMM dates
IMM dates
The IMM dates are the four quarterly dates of each year which most futures contracts and option contracts use as their scheduled maturity date or termination date...
, which fall on the third Wednesday of these months, these CDS maturity dates are also referred to as "IMM dates".
Physical or cash
As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash settled.- Physical settlement: The protection seller pays the buyer par value, and in return takes delivery of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. In the event of a default, the bank pays the hedge fund $5 million cash, and the hedge fund must deliver $5 million face value of senior debt of the company (typically bonds or loans, which are typically worth very little given that the company is in default).
- Cash settlement: The protection seller pays the buyer the difference between par value and the market price of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. This company has now defaulted, and its senior bonds are now trading at 25 (i.e., 25 cents on the dollar) since the market believes that senior bondholders will receive 25% of the money they are owed once the company is wound up. Therefore, the bank must pay the hedge fund $5 million * (100%-25%) = $3.75 million.
The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations. (This is because many parties made CDS contracts for speculative purposes, without actually owning any debt that they wanted to insure against default.) For example, at the time it filed for bankruptcy on September 14, 2008, Lehman Brothers had approximately $155 billion of outstanding debt but around $400 billion notional value of CDS contracts had been written that referenced this debt. Clearly not all of these contracts could be physically settled, since there was not enough outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for cash settled CDS trades. The trade confirmation produced when a CDS is traded states whether the contract is to be physically or cash settled.
Auctions
When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction (also known as a credit-fixing event) may be held to facilitate settlement of a large number of contracts at once, at a fixed cash settlement price. During the auction process participating dealers (e.g., the big investment banks) submit prices at which they would buy and sell the reference entity's debt obligations, as well as net requests for physical settlement against par. A second stage Dutch auctionDutch auction
A Dutch auction is a type of auction where the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneer's price, or a predetermined reserve price is reached. The winning participant pays the last announced price...
is held following the publication of the initial mid-point of the dealer markets and what is the net open interest to deliver or be delivered actual bonds or loans. The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled. According to the International Swaps and Derivatives Association
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
(ISDA), who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
and Washington Mutual
Washington Mutual
Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....
.
Below is a list of the auctions that have been held since 2005.
| Date | Name | Final price as a percentage of par |
|---|---|---|
| 2005-06-14 | Collins & Aikman Collins & Aikman Collins & Aikman Corporation was a manufacturer of cockpit modules and automotive floor and acoustic systems and a supplier of instrument panels, automotive fabric, plastic based trim and convertible top systems... - Senior |
43.625 |
| 2005-06-23 | Collins & Aikman Collins & Aikman Collins & Aikman Corporation was a manufacturer of cockpit modules and automotive floor and acoustic systems and a supplier of instrument panels, automotive fabric, plastic based trim and convertible top systems... - Subordinated |
6.375 |
| 2005-10-11 | Northwest Airlines Northwest Airlines Northwest Airlines, Inc. was a major United States airline founded in 1926 and absorbed into Delta Air Lines by a merger approved on October 29, 2008, making Delta the largest airline in the world... |
28 |
| 2005-10-11 | Delta Air Lines Delta Air Lines Delta Air Lines, Inc. is a major airline based in the United States and headquartered in Atlanta, Georgia. The airline operates an extensive domestic and international network serving all continents except Antarctica. Delta and its subsidiaries operate over 4,000 flights every day... |
18 |
| 2005-11-04 | Delphi Corporation | 63.375 |
| 2006-01-17 | Calpine Corporation | 19.125 |
| 2006-03-31 | Dana Corporation | 75 |
| 2006-11-28 | Dura Dura Automotive Systems Dura Automotive Systems, headquartered in Rochester Hills, Michigan, USA was ranked in the 2006 Fortune 1000. It is engaged in the business of manufacturing and distribution of automotive components.... - Senior |
24.125 |
| 2006-11-28 | Dura Dura Automotive Systems Dura Automotive Systems, headquartered in Rochester Hills, Michigan, USA was ranked in the 2006 Fortune 1000. It is engaged in the business of manufacturing and distribution of automotive components.... - Subordinated |
3.5 |
| 2007-10-23 | Movie Gallery Movie Gallery Movie Gallery, Inc. was the second largest movie and game rental company in the United States, behind Blockbuster Video. The company rented and sold Blu-ray Discs, DVDs, VHS tapes, and video games... |
91.5 |
| 2008-02-19 | Quebecor World Quebecor World Quebecor World Inc. was a printing subsidiary of Quebecor Inc. based in Montreal, Quebec. It comprised a number of small and large print shops throughout the world. In 2010, Quebecor World was acquired by Wisconsin-based Quad/Graphics.... |
41.25 |
| 2008-10-02 | Tembec Inc | 83 |
| 2008-10-06 | Fannie Mae - Senior | 91.51 |
| 2008-10-06 | Fannie Mae - Subordinated | 99.9 |
| 2008-10-06 | Freddie Mac - Senior | 94 |
| 2008-10-06 | Freddie Mac - Subordinated | 98 |
| 2008-10-10 | Lehman Brothers Lehman Brothers Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker... |
8.625 |
| 2008-10-23 | Washington Mutual Washington Mutual Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008.... |
57 |
| 2008-11-04 | Landsbanki Landsbanki Landsbanki, also commonly known as Landsbankinn in Iceland, is a private Icelandic bank with international operations... - Senior |
1.25 |
| 2008-11-04 | Landsbanki Landsbanki Landsbanki, also commonly known as Landsbankinn in Iceland, is a private Icelandic bank with international operations... - Subordinated |
0.125 |
| 2008-11-05 | Glitnir Glitnir (bank) Glitnir was an international Icelandic bank. It was created by the state-directed merger of the country's three privately held banks - Alþýðubanki , Verzlunarbanki and Iðnaðarbanki - and one failing publicly held bank - Útvegsbanki - to form Íslandsbanki in 1990... - Senior |
3 |
| 2008-11-05 | Glitnir Glitnir (bank) Glitnir was an international Icelandic bank. It was created by the state-directed merger of the country's three privately held banks - Alþýðubanki , Verzlunarbanki and Iðnaðarbanki - and one failing publicly held bank - Útvegsbanki - to form Íslandsbanki in 1990... - Subordinated |
0.125 |
| 2008-11-06 | Kaupthing - Senior | 6.625 |
| 2008-11-06 | Kaupthing - Subordinated | 2.375 |
| 2008-12-09 | Masonite http://www.masonite.com/ - LCDS | 52.5 |
| 2008-12-17 | Hawaiian Telcom Hawaiian Telcom Hawaiian Telcom is the incumbent local exchange carrier or dominant local telephone company, serving the state of Hawaii. It was formed in 2005 by The Carlyle Group, following its purchase of the Hawaii assets of Verizon Communications, which was known as Verizon Hawaii, Inc., and previously as... - LCDS |
40.125 |
| 2009-01-06 | Tribune Tribune Company The Tribune Company is a large American multimedia corporation based in Chicago, Illinois. It is the nation's second-largest newspaper publisher, with ten daily newspapers and commuter tabloids including Chicago Tribune, Los Angeles Times, Hartford Courant, Orlando Sentinel, South Florida... - CDS |
1.5 |
| 2009-01-06 | Tribune Tribune Company The Tribune Company is a large American multimedia corporation based in Chicago, Illinois. It is the nation's second-largest newspaper publisher, with ten daily newspapers and commuter tabloids including Chicago Tribune, Los Angeles Times, Hartford Courant, Orlando Sentinel, South Florida... - LCDS |
23.75 |
| 2009-01-14 | Republic of Ecuador Ecuador Ecuador , officially the Republic of Ecuador is a representative democratic republic in South America, bordered by Colombia on the north, Peru on the east and south, and by the Pacific Ocean to the west. It is one of only two countries in South America, along with Chile, that do not have a border... |
31.375 |
| 2009-02-03 | Millennium America Inc | 7.125 |
| 2009-02-03 | Lyondell - CDS | 15.5 |
| 2009-02-03 | Lyondell - LCDS | 20.75 |
| 2009-02-03 | EquiStar EquiStar Group EquiStar Group is a commercial real estate financial advisory company located in the New York metropolitan area . They combine technology with the commercial real estate industry. EquiStar advises in the acquisition, financing, repositioning, work-out and disposition of real estate assets... |
27.5 |
| 2009-02-05 | Sanitec http://www.sanitec.com/ - 1st Lien | 33.5 |
| 2009-02-05 | Sanitec http://www.sanitec.com/ - 2nd Lien | 4.0 |
| 2009-02-09 | British Vita http://www.britishvita.com/ - 1st Lien | 15.5 |
| 2009-02-09 | British Vita http://www.britishvita.com/ - 2nd Lien | 2.875 |
| 2009-02-10 | Nortel Ltd. | 6.5 |
| 2009-02-10 | Nortel Corporation | 12 |
| 2009-02-19 | Smurfit-Stone CDS | 8.875 |
| 2009-02-19 | Smurfit-Stone LCDS | 65.375 |
| 2009-02-26 | Ferretti | 10.875 |
| 2009-03-09 | Aleris | 8 |
| 2009-03-31 | Station Casinos | 32 |
| 2009-04-14 | Chemtura | 15 |
| 2009-04-14 | Great Lakes | 18.25 |
| 2009-04-15 | Rouse | 29.25 |
| 2009-04-16 | LyondellBasell | 2 |
| 2009-04-17 | Abitibi | 3.25 |
| 2009-04-21 | Charter Communications CDS | 2.375 |
| 2009-04-21 | Charter Communications LCDS | 78 |
| 2009-04-22 | Capmark | 23.375 |
| 2009-04-23 | Idearc CDS | 1.75 |
| 2009-04-23 | Idearc LCDS | 38.5 |
| 2009-05-12 | Bowater | 15 |
| 2009-05-13 | General Growth Properties | 44.25 |
| 2009-05-27 | Syncora | 15 |
| 2009-05-28 | Edshcha | 3.75 |
| 2009-06-09 | HLI Operating Corp LCDS | 9.5 |
| 2009-06-10 | Georgia Gulf LCDS | 83 |
| 2009-06-11 | R.H. Donnelley Corp. CDS | 4.875 |
| 2009-06-12 | General Motors CDS | 12.5 |
| 2009-06-12 | General Motors LCDS | 97.5 |
| 2009-06-18 | JSC Alliance Bank CDS | 16.75 |
| 2009-06-23 | Visteon CDS | 3 |
| 2009-06-23 | Visteon LCDS | 39 |
| 2009-06-24 | RH Donnelley Inc LCDS | 78.125 |
| 2009-07-09 | Six Flags CDS | 14 |
| 2009-07-09 | Six Flags LCDS | 96.125 |
| 2009-07-21 | Lear CDS | 38.5 |
| 2009-07-21 | Lear LCDS | 66 |
| 2009-11-10 | METRO-GOLDWYN-MAYER INC. LCDS | 58.5 |
| 2009-11-20 | CIT Group Inc. | 68.125 |
| 2009-12-09 | Thomson | 77.75 |
| 2009-15-09 | Hellas II | 1.375 |
| 2009-12-16 | NJSC Naftogaz of Ukraine | 83.5 |
| 2010-01-07 | Financial Guarantee Insurance Compancy (FGIC) | 26 |
| 2010-02-18 | CEMEX | 97.0 |
| 2010-03-25 | Aiful | 33.875 |
| 2010-04-15 | McCarthy and Stone | 70.375 |
| 2010-04-22 | Japan Airlines Corp | 20.0 |
| 2010-06-04 | Ambac Assurance Corp | 20.0 |
| 2010-07-15 | Truvo Subsidiary Corp | 3.0 |
| 2010-09-09 | Truvo (formerly World Directories) | 41.125 |
| 2010-09-21 | Boston Generating LLC | 40.75 |
| 2010-10-28 | Takefuji Corp | 14.75 |
| 2010-12-09 | Anglo Irish Bank | 18.25 |
| 2010-12-10 | Ambac Financial Group | 9.5 |
Pricing and valuation
There are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to herein as the 'probability model', takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.The second model, proposed by Darrell Duffie
Darrell Duffie
James Darrell Duffie is a Canadian economist. He is the Dean Witter Distinguished Professor of Finance at Stanford Graduate School of Business, and has been on the finance faculty at Stanford since receiving his Ph.D. from Stanford in 1984...
, but also by John Hull and White, uses a no-arbitrage approach.
Probability model
Under the probability model, a credit default swap is priced using a model that takes four inputs; this is similar to the rNPVRNPV
In finance, rNPV or eNPV is a method to value risky future cash flows. rNPV modifies the standard NPV calculation of discounted cash flow analysis by adjusting each cash flow by the estimated probability that it occurs...
(risk-adjusted NPV) model used in drug development
Drug development
Drug development is a blanket term used to define the process of bringing a new drug to the market once a lead compound has been identified through the process of drug discovery...
:
- the "issue premium",
- the recovery rate (percentage of notional repaid in event of default),
- the "credit curve" for the reference entity and
- the "LIBOR curve".
If default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
events never occurred the price of a CDS would simply be the sum of the discounted
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. For the purpose of explanation we can imagine the case of a one year CDS with effective date
with four quarterly premium payments occurring at times , , , and . If the nominal for the CDS is and the issue premium is then the size of the quarterly premium payments is . If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end:
- either it does not have any default at all, so the four premium payments are made and the contract survives until the maturity date, or
- a default occurs on the first, second, third or fourth payment date.
To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the five payoffs multiplied by their probability of occurring.
This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in which case it ends with a payment of
shown in red, where is the recovery rate, or it survives without a default being triggered, in which case a premium payment of is made, shown in blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.The probability of surviving over the interval
to without a default payment is and the probability of a default being triggered is . The calculation of present value, given discount factor of to is then| Description | Premium Payment PV | Default Payment PV | Probability |
|---|---|---|---|
Default at time  |
 |
 |
 |
Default at time  |
 |
 |
 |
Default at time  |
 |
 |
 |
Default at time  |
 |
 |
 |
| No defaults |  |
 |
 |
The probabilities
, , , can be calculated using the credit spreadCredit spread (bond)
The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk...
curve. The probability of no default occurring over a time period from
to decays exponentially with a time-constant determined by the credit spread, or mathematically where is the credit spreadCredit spread (bond)
The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk...
zero curve at time
. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time.To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give
 |
 |
 |
 |
||
 |
||
 |
||
 |
No-arbitrage model
In the 'no-arbitrage' model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free arbitrage. Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the risk free rate. Both analyses make simplifying assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default), which may invalidate the no-arbitrage assumption. However the Duffie approach is frequently used by the market to determine theoretical prices.Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a CDS contract should trade at 30. However there are sometimes technical reasons why this will not be the case, and this may or may not present an arbitrage opportunity for the canny investor. The difference between the theoretical model and the actual price of a credit default swap is known as the basis.
Criticisms
Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency. Furthermore, there have even been claims that CDSs exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIGAmerican International Group
American International Group, Inc. or AIG is an American multinational insurance corporation. Its corporate headquarters is located in the American International Building in New York City. The British headquarters office is on Fenchurch Street in London, continental Europe operations are based in...
.
In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default.
Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the 2009 General Motors Chapter 11 reorganization
General Motors Chapter 11 reorganization
The General Motors Chapter 11 sale of the assets of automobile manufacturer General Motors and some of its subsidiaries was implemented through section 363 of Chapter 11, Title 11, United States Code in the United States Bankruptcy Court for the Southern District of New York...
, because bondholders would benefit from the credit event of a GM bankruptcy due to their holding of CDSs. Critics speculate that these creditors were incentivized into pushing for the company to enter bankruptcy protection. Due to a lack of transparency, there was no way to find out who the protection buyers and protection writers were, and they were subsequently left out of the negotiation process.
It was also reported after Lehman's bankruptcy that the $400 billion notional of CDS protection which had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers (given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts could lead to further bankruptcies of firms without enough cash to settle their contracts. However, industry estimates after the auction suggested that net cashflows would only be in the region of $7 billion.
This is because many parties held offsetting positions; for example if a bank writes CDS protection on a company it is likely to then enter an offsetting transaction by buying protection on the same company in order to hedge its risk. Furthermore, CDS deals are marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, meaning that the net cashflows on the days after the auction are likely to have been even lower.
Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis, but that CDS contracts have been acting to distribute risk just as was intended, and that it is not CDSs themselves that need further regulation, but the parties who trade them.
Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway
Berkshire Hathaway
Berkshire Hathaway Inc. is an American multinational conglomerate holding company headquartered in Omaha, Nebraska, United States, that oversees and manages a number of subsidiary companies. The company averaged an annual growth in book value of 20.3% to its shareholders for the last 44 years,...
's annual report to shareholders in 2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."
To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on one's counterparty. The positions are marked-to-market daily and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money does not always change hands due to the offset of gains and losses by those who had both bought and sold protection. Depository Trust & Clearing Corporation, the clearinghouse for the majority of trades in the US over-the-counter market, stated in October 2008 that once offsetting trades were considered, only an estimated $6 billion would change hands on October 21, during the settlement of the CDS contracts issued on Lehman Brothers' debt, which amounted to somewhere between $150 to $360 billion.
Despite Buffett's criticism on derivatives, in October 2008 Berkshire Hathaway revealed to regulators that it has entered into at least $4.85 billion in derivative transactions. Buffett stated in his 2008 letter to shareholders that Berkshire Hathaway has no counterparty risk in its derivative dealings because Berkshire require counterparties to make payments when contracts are inititated, so that Berkshire always holds the money. Berkshire Hathaway was a large owner of Moody's stock during the period that it was one of two primary rating agencies for subprime CDOs, a form of mortgage security derivative dependant on the use of credit default swaps.
The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the monolines. In 2009 one of the monolines, MBIA, sued Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
, claiming that Merill had misrepresented some of its CDOs to MBIA in order to persuade MBIA to write CDS protection for those CDOs.
Systemic risk
The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly because Lehman Brothers and AIG were counterparties in a very large number of CDS transactions. This is an example of systemic riskSystemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
, risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.
For example, imagine if a hypothetical mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
had bought some Washington Mutual
Washington Mutual
Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....
corporate bonds in 2005 and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After Lehman's default, this protection was no longer active, and Washington Mutual's sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. There was also fear that Lehman Brothers and AIG's inability to pay out on CDS contracts would lead to the unraveling of complex interlinked chain of CDS transactions between financial institutions. So far this does not appear to have happened, although some commentators have noted that because the total CDS exposure of a bank is not public knowledge, the fear that one could face large losses or possibly even default themselves was a contributing factor to the massive decrease in lending liquidity during September/October 2008.
Chains of CDS transactions can arise from a practice known as "netting". Here, company B may buy a CDS from company A with a certain annual premium, say 2%. If the condition of the reference company worsens, the risk premium rises, so company B can sell a CDS to company C with a premium of say, 5%, and pocket the 3% difference. However, if the reference company defaults, company B might not have the assets on hand to make good on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to company C.
The problem lies if one of the companies in the chain fails, creating a "domino effect
Domino effect
The domino effect is a chain reaction that occurs when a small change causes a similar change nearby, which then will cause another similar change, and so on in linear sequence. The term is best known as a mechanical effect, and is used as an analogy to a falling row of dominoes...
" of losses. For example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company. Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A; it is only doing business with company B.
As described above, the establishment of a central exchange or clearing house for CDS trades would help to solve the "domino effect" problem, since it would mean that all trades faced a central counterparty guaranteed by a consortium of dealers.
Tax and accounting issues
The U.S federal income tax treatment of credit default swaps is uncertain. Commentators generally believe that, depending on how they are drafted, they are either notional principal contractNotional principal contract
The term notional principal contract is a term of art used by U.S. federal income tax professionals for contracts based on an underlying notional amount...
s or options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
for tax purposes, but this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).
If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income. If a payment is a termination payment, its tax treatment is even more uncertain. In 2004, the Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
announced that it was studying the characterization of credit default swaps in response to taxpayer confusion, but it has not yet issued any guidance on their characterization. A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States.
The accounting treatment of Credit Default Swaps used for hedging may not parallel the economic effects and instead, increase volatility. For example, GAAP generally require that Credit Default Swaps be reported on a mark to market
Mark to market
Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value...
basis. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce considerable volatility into the income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
and balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
as the CDS changes value over its life due to market conditions and due to the tendency for shorter dated CDS to sell at lower prices than longer dated CDS. One can try to account for the CDS as a hedge under FASB 133 but in practice that can prove very difficult unless the risky asset owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular CDS that was bought.
LCDS
A new type of default swap is the "loan only" credit default swap (LCDS). This is conceptually very similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of "Bond or Loan". Also, as of May 22, 2007, for the most widely traded LCDS form, which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same that has been used in the various ISDA cash settlement auction protocols, but does not require parties to take any additional steps following a credit event (i.e., adherence to a protocol) to elect cash settlement. On October 23, 2007, the first ever LCDS auction was held for Movie GalleryMovie Gallery
Movie Gallery, Inc. was the second largest movie and game rental company in the United States, behind Blockbuster Video. The company rented and sold Blu-ray Discs, DVDs, VHS tapes, and video games...
.
Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed the cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name.
See also
- Bucket shop (stock market)Bucket shop (stock market)As defined by the U.S. Supreme Court a Bucket shop is "[a]n establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain,...
- Constant maturity credit default swapConstant Maturity Credit Default SwapA constant maturity credit default swap is a type of credit derivative product, similar to a standard Credit Default Swap . Addressing CMCDS typically requires prior understanding of credit default swaps....
- Credit default optionCredit default optionIn finance, a default option, credit default swaption or credit default option is an option to buy protection or sell protection as a credit default swap on a specific reference credit with a specific maturity...
- Credit default swap indexCredit Default Swap IndexA credit default swap index is a credit derivative used to hedge credit risk or to take a position on a basket of credit entities. Unlike a credit default swap, which is an over the counter credit derivative, a credit default swap index is a completely standardised credit security and may...
- CUSIP Linked MIP CodeCUSIP Linked MIP CodeThe CUSIP-linked MIP code is used in the financial derivatives markets to identify the reference entity of a credit default swap. It is mainly used as a key field in Markit's reference entity database . Each CLIP is linked with one or more CUSIPs each representing reference entity obligations .For...
Reference Entity Code(CLIP) - Inside Job (film)Inside Job (film)Inside Job is a 2010 documentary film about the late-2000s financial crisis directed by Charles H. Ferguson. The film is described by Ferguson as being about "the systemic corruption of the United States by the financial services industry and the consequences of that systemic corruption." In five...
, a 2010 Oscar-winning documentary film about the financial crisis of 2007–2010 by Charles H. Ferguson - Recovery swapRecovery SwapIn finance, recovery swaps, recovery locks, or recovery default swaps are derivative contracts related to credit default swaps, and reference a bond issuance as its underlying...
- Toxic securityToxic securityToxic Security is the name applied during the aftermath of the subprime meltdown to financial instruments which cannot be readily identified as an asset or a liability. According to George Soros, "the toxic securities in question are not homogeneous."...
External links
- Barroso considers ban on speculation with banning purely speculative naked sales on credit default swaps of sovereign debt
- "Systemic Counterparty Confusion: Credit Default Swaps Demystified". Derivative DribbleDerivative DribbleDerivative Dribble is a blog written by Charles Davi focused on finance, particularly derivatives and structured products. The site explains how various financial instruments work and why they are used...
. October 23, 2008. - CBS '60 minutes' video on CDS
- 2003 ISDA Credit Derivatives Template. International Swaps and Derivatives AssociationInternational Swaps and Derivatives AssociationThe International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
- BIS - Regular Publications. Bank for International SettlementsBank for International SettlementsThe Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
. - A Beginner's Guide to Credit Derivatives - Nomura International Probability.net
- "A billion-dollar game for bond managers". Financial TimesFinancial TimesThe Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
. - John C. Hull and Alan White. "Valuing Credit Default Swaps I: No Counterparty Default Risk". University of TorontoUniversity of TorontoThe University of Toronto is a public research university in Toronto, Ontario, Canada, situated on the grounds that surround Queen's Park. It was founded by royal charter in 1827 as King's College, the first institution of higher learning in Upper Canada...
. - Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations. Smartquant.com
- Elton et al., Explaining the rate spread on corporate bonds
- Warren Buffett on Derivatives - Excerpts from the Berkshire Hathaway annual report for 2002. fintools.com
- The Real Reason for the Global Financial Crisis. Financial Sense Archive
- Demystifying the Credit Crunch. Private Equity CouncilPrivate Equity CouncilThe Private Equity Growth Capital Council , formerly the Private Equity Council, is the lobbying, advocacy and research organization for the private equity industry. The PEC was founded by a consortium of the largest private equity firms globally...
. - The AIG Bailout William Sjostrom, Jr.
- Standard CDS Pricing Model Source Code - ISDA and Markit. CDSModel.com
- List of CDS premiums of various countries in English translation from German
News
- Zweig, Phillip L. (July 1997), BusinessWeek New ways to dice up debt - Suddenly, credit derivatives-deals that spread credit risk--are surging
- Goodman, Peter (Oct 2008) New York Times The spectacular boom and calamitous bust in derivatives trading
- Pulliam, Susan and Ng, Serena (January 18, 2008), Wall Street Journal: "Default Fears Unnerve Markets"
- Das, Satayjit (February 5, 2008), Financial Times: "CDS market may create added risks"
- Morgenson, Gretchen (February 17, 2008), New York Times: "Arcane Market is Next to Face Big Credit Test"
- March 17, 2008 Credit Default Swaps: The Next Crisis?, Time
- Schwartz, Nelson D. and Creswell, Julie (March 23, 2008), New York Times: "Who Created This Monster?"
- Evans, David (May 20, 2008), Bloomberg: "Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults"
- van Duyn, Aline (May 28, 2008), Financial Times: "Moody's issues warning on CDS risks"
- Morgenson, Gretchen (June 1, 2008), New York Times: "First Comes the Swap. Then It’s the Knives."
- Kelleher, James B. (September 18, 2008), Reuters: "Buffett's 'time bomb' goes off on Wall Street."
- Morgenson, Gretchen (September 27, 2008), New York Times: "Behind Insurer’s Crisis, Blind Eye to a Web of Risk"
- Varchaver, Nicholas and Benner, Katie (Sep 2008), Fortune Magazine: "The $55 Trillion Question" - on CDS spotlight during financial crisis.
- October 19, 2008, Portfolio.com: "Why the CDS Market Didn't Fail" Analyzes the CDS market's performance in the Lehman Bros. bankruptcy.
- Boumlouka, Makrem (April 8, 2009), Wall Street Letter: "Credit Default Swap Market: “Big Bang”? ".