On the surface, credit derivatives are no different from other products seeking to transfer risk from one party to another. The risk transferred is based upon the credit performance of corporations, sovereign entities or other types of debt obligations.
These instruments initially arose out of a demand for hedging and diversifying credit exposures, just like other forms of derivatives developed to hedge currencies, interest rates or equity risks. But they have since evolved into much more.
There are myriads of credit derivatives, ranging from the basic credit default swap (CDS) that encompasses almost 90% of the total credit derivatives market, to more complicated structures such as total-return swaps, credit-linked notes, credit-default swap options, credit-spread options and forwards, asset swaps, and synthetic collateralized debt obligations.
We’ll focus on the most popular type of credit derivatives—CDSs (not to be confused with the Canadian Depository for Securities, a clearing organization).
Credit default swaps
The mechanics of a CDS are straight forward. A protection buyer pays a premium to the protection seller to protect against an adverse credit event on the reference entity.
This is similar to a homeowner (the protection buyer) paying a premium (the house insurance payment) to an insurance company (the protection seller) to protect the homeowner against a fire or other adverse event on their home (the reference entity).There are CDSs that cover just one debt obligation, called single-name CDSs, or multiname CDSs that represent several debt obligations. More recently, CDSs have been introduced on indexes as well.
A practical application of a CDS is where a bondholder purchases a bond in a particular company and receives a periodic interest payment from the bond.
At maturity, the principal amount is returned to the bondholder; however, the return of the principal is not assured if the company is experiencing financial difficulties. By purchasing a CDS, a payment is made in case the company defaults on repaying the principal amount of the bond—the bondholder is now protected from such an event.
A notable point in both the example above and the previous homeowner scenarios is the parties actually have a financial interest in what is being protected (bond or home).That is not always the case, however, with a CDS. An oft-cited criticism is that the CDS purchaser can speculate and buy insurance on somebody else’s house and then benefit when it burns down.
When CDS trading began in the mid-1990s, it was almost exclusively a product used by banks to free up regulatory capital by transferring credit risk from commercial loans to a third party.
However, as the product developed, it transformed into an instrument also used as a speculative tool by other entities such as broker dealers, institutional investors, hedge funds and insurers.This led to as much as 50% of the CDS business being used for speculative, non-hedging purposes.
The speculative nature of CDS trading is particularly noteworthy since the risks and rewards of this speculation are not symmetrical.
The protection buyer only risks the premium paid to the protection seller, while the protection seller risks substantially more, due to insuring the value of the reference entity. In this intricate market, many risk factors come into play, as AIG found out when it sold CDS protection and ended up responsible for substantial losses in the pending liquidity crisis.
Since the financial crisis in 2008, global CDS activity has slowed but still remains at a level where it represents almost $20 trillion of notional value and almost 5% of the massive market for over-the-counter (OTC) derivatives.
1 National amounts outstanding in trillions of US dollars (right-hand scale)
2 As a percentage of the notional amount outstanding of all OTC derivatives (gross market values on left-hand scale)
Sources: Central Banks of the G10 countries and Switzerland; BIS
Despite a drop-off in CDS volume following 2008, there has recently been a pickup in activity with trading for the first half of 2011—up almost 8%, according to the Bank for International Settlements, a major reporting agency on CDSs and other financial instruments. This may indicate a trend back to additional CDS trading following a post-crisis drop-off.
Of the CDS volume that is trading, a majority of the activity is in the single-name CDSs transacted by reporting dealers and other financial institutions. This shows a modest preference over protection on a single entity versus more widespread protection on a broader multi-name spectrum or index.
Single-name versus multi-name index
1National amounts outstanding.
2Gross market values