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26 mars 2012

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Credit Default Swap and Insurance (1/3)

By Guillaume Fort. In the early 1990s, JP Morgan and some other banks developed the first credit default swaps in order to protect themselves against their exposure to large corporate loans they made to their clients. 
From a relatively small market measured in the low hundreds of billions by the late 1990s, the product exploded during the last decade and today their gross notional is estimated to be close to 28 trillion of US dollars. 

1. Definitions of CDS and Insurance

A Credit Default Swap agreement (hereafter the “CDS”) is a financial derivative instrument where the seller of the CDS will compensate the buyer when a particular event is triggered as a loan default or other credit event. 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.
In a CDS, the buyer of "protection" gives a series of payments to the seller. If a "credit event" (either a default, debt restructuring or repudiation) is triggered, the buyer then receives a large payoff. 
Being a financial instrument, CDS is not subject to the same regulations that insurance companies are. Each swap requires a form regulated by the International Swaps and Derivatives Association (ISDA).
Insurance is  “a contract whereby, for specified consideration, one party undertakes to compensate the other for a loss relating to a particular subject as a result of the occurrence of designated hazards”.

The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to indemnify the insured in the case of a financial or personal loss. The insurance policy is the contract that the insured receives, which details the conditions and circumstances under which the insured will be financially compensated.

2. How CDS differs with Insurance ?

Essentially, CDS looks like a form of insurance on bonds that allow the buyer to offset the risk that a borrower will default on their interest payments to an investor willing to take the risk. 
However, as Christopher L. Culp says in his book “Structured Finance & Insurance”: “Perhaps the main distinction between a CDS and credit insurance is that credit protection purchaser in a CDS need not own the reference asset”. 
“The reference asset may be owned by the CDS buyer, but this need not be – and often is not – the case. In other words, unlike insurance, the protection buyer in a CDS does not need to have an insurable interest in the reference asset for which protection is being purchased”.

3. How does it work?

A CDS is nothing more than a contract in which one party (the protection seller agrees to reimburse another party (the protection buyer) against default on a financial obligation by a third party (the reference entity).

The scheme hereinbefore shows a series of simple CDS transactions. The reference entity is A, the protection buyer is B, and the protection seller is C. Bank B has bought a $10 million bond from company A, so B has now exposure to A. If B does not want to keep this risk –perhaps B believes that A’s prospects are declining, or perhaps it wants to diversify its assets – it has two choices: sell the bond or transfer the risk credit.
For a variety of tax and other reasons, B may not want to sell the bond. But it is able to eliminate most of all of the credit risk of keeping the bond and entering into a CDS contracts with counterparty, C.

The right of recovery generally rests with the owner of the reference asset. As this point, cash-settled CDS must be distinguished from physically settled CDS. 
  • In a cash-settled CDS, the credit protection buyer receives a payment equal to the par value of the security minus the expected recovery, but if the protection buyer owns the asset it can try to improve the actual recovery relative to the expectation reflected in the security price. 
  • In the physically settled CDS, by contrast, the bond and the recovery right are given to the swap dealer in exchange for a cash payment equal to the par value of the security.

If the protection buyer owns the asset and believes it can improve on the recovery rate priced into the security, the protection buyer is clearly better off the cash-settled CDS.
All European credit default swaps used the form of  the “master agreement” issued by the International Swaps and Derivatives Association (ISDA), a trade association of all the world’s leading investment banks and investors in so-called OTC [over-the-counter] derivatives. 
The term OTC is important as the CDS market is a dealer market, so transactions take place over the counter rather than on an exchange. 
4. What is a “credit event”?

A “credit event”, which is the technical term for a default as the failure to pay, can be difficult to reckon therefore there are five regional ISDA credit determinations committees comprised of banks and major credit investors that sit as the ultimate arbiters on the issue. 
The European committee includes banks such as Barclays, Goldman Sachs and Royal Bank of Scotland, and investors, including BlackRock and Citadel Investment Group. 
Any investor  can request a request concerning a “credit event" to the committee and should they decide to accept the query, the committee will assess the claim to determine whether the right of protection under the CDS should be triggered. It has been recently the case in Greece where CDS have been triggered due to a sovereign credit default.

5. Who trades in CDS and why?

Four main groups of market participants in the CDS market may be identified: dealers, non-dealer banks, hedge funds and asset managers. The dealers are by far the largest players on the market. These market participants have diverse aims and employ different strategies.CDS can be used for the following purposes:

  • hedging: CDS is a good way for the CDS buyer to reduce a risky position to another position. An example would be a bondholder's exposure to the credit risk of the issuer of the bond: the purchase of a CDS would be the best manner to reduce a risk by passing it on to the CDS seller;
  • speculation: CDS is often used as a speculative instrument where the CDS seller takes a position in order to exploit price changes by trading in and out. For example, a CDS seller has taken on risk in exchange for a spread (a series of payment) from the CDS buyer. The CDS seller will gain from the contract if the credit risk does not materialize during the contract's term or if the CDS fees received by the seller exceed the final payout in the case a credit risk occurred.
  • arbitrage: lastly, CDS can be seen as an arbitrage operation that involves the combination of buying a CDS and entering into an asset swap where the fixed coupon payments of a bond are swapped against a stream of variable payments 

6. Is there a link between CDS and the Crisis ? 

After the 2008 financial crisis, interconnections and lack of transparency of the CDS market were thought as one way that an individual business, such as Lehman Brothers, might cause a larger financial collapse. Due to the CDS market's systemic risk, size and lack of regulation, CDS were  seen  as a threat to the stability of the financial system. 
In fact, critics of CDS argue that the interconnections they create might lead to systemic risks as each member of the string of transactions defaults because of the new liability it must assume. 
This analysis might appear superficial: regarding the scheme hereinbefore, if CDS did not exist, B would certainly suffer the loss associated with A’s default, and there is no reason to believe that the loss would stop with B. B is undoubtedly indebted to others, and its loss on the loan to A might cause B to default on these obligations, just as E’s default might have caused D to default on its obligations to C.  
As Peter J. Wallison says, “in other words, the credit markets are already interconnected. That is their very purpose. With or without credit-default swaps, the failure of a large enough participant can – at least theoretically – send a cascade of losses through a highly interconnected structure”.
CDS simply move the risk of the result from one entity to another. However, they do not materially increase the risk created when, in our above example, B made its loan to A. As a result, it could be wrong to say that CDS have played a significant role in the crisis by increasing systemic risks.

7. What will be our study?

Next article will try to answer to two major issues related to CDS: what are the main difference between CDS and Insurance and how CDS are nowadays regulated in the US and in Europe. 
As a result, we will first focus on a technical comparative analysis between CDS and Insurance, widely understood as including both Insurance and Reinsurance, and then we will compare CDS’ regulation in the United States and in Europe. 

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