More credit for credit derivatives

By Bud Haslett | June 25, 2012 | Last updated on June 25, 2012
6 min read

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.

Default protection

Default protection

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.

Asymmetric speculation

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.

OTC derivatives

Credit default swaps

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

Single-name versus multi-name index

1National amounts outstanding.

2Gross market values

Regulatory changes

A major factor shaping the CDS volume and market in general is the regulatory changes currently taking place. In an effort to provide transparency to a previously opaque market, trading information on credit derivatives is now being collected and stored.

Organizations such as the Depository Trust and Clearing Corporation (DTCC) currently report data on approximately 98% of the CDS trades executed in the global markets.

Stewart Macbeth, president and CEO of DTCC Deriv/SERV LLC, states, “The availability of the data in one centralized location, along with its comprehensiveness, has brought increased transparency and risk mitigation to this important segment of the financial markets, supporting regulatory, legislative and industry objectives.”

DTCC makes major portions of this information available to the public at no charge and has set up a portal specifically for global regulators so they can monitor systemic risk by viewing credit-derivative exposures. An example of the data can be seen in the most active issues in single-name sovereign debt CDSs.

Examining this newly transparent data on individual activity can highlight popular areas of CDS trading as well as offer insights into potential problem zones. Active CDSs such as the Republic of Italy, the Kingdom of Spain and the French Republic have large volumes for a reason.

Typically, these issues deal with credit concerns, or some mispricing in credit risk, knowledge of which can be valuable for investment decision-making.

Increases in premium levels can also signal signs of problems before many developments are publicly recognized, and may provide insights for your clients even if you’re not an active participant in the CDS market.

Oftentimes, CDS premiums rise in advance of many of the actual events, providing an early warning of pending problems in the market.

For example, the premium for the Euro area rose as credit issues began to develop in those markets. It’s important to realize for every buyer of credit protection there must be a seller; and a seller’s reluctance to provide protection at the current premium level, or a protection buyer’s urgency to purchase the protection, leads to higher premiums.

This is the basic force behind an increase in CDS premiums and the potential predictive value present in the CDS market.

Increasing market transparency also allows investors to anticipate an expected default rate for the particular security. It can also often provide valuable insights for investors in this and other types of fixed income investments.

Credit default swap premia for banks in Europe and the United States1

One need not be distressed at the noticeable absence of Canadian banks from much of the CDS data. Overall, these banks managed their risks far better than their global counterparts and therefore their demand for credit protection is much lower for these issuers.

Credit derivatives

J.P. Morgan’s Blythe Masters is widely credited for creating the CDS. In her firm’s guide on credit derivatives, Masters states, “In bypassing barriers between different classes, maturities, rating categories, debt seniority levels and so on, credit derivatives are creating enormous opportunities to exploit and profit from associated discontinuities in the pricing of credit risk.”

Are these opportunities an average advisor can take advantage of? Only you can really answer that question. I view credit derivatives as another valuable tool to transfer risk. But then again, they must be properly used—misuse of credit derivatives can be disastrous.

It is better to avoid a tool when you cannot properly use it in a well-informed manner. This does not mean understanding the CDS market cannot be valuable to you. By evaluating changes in CDS volumes, premium levels and default characteristics, advisors can use insights from the CDS market to enhance a client’s financial well being. Even if you don’t trade in these markets, credit derivatives need not be a foe. On the contrary, they can be valuable friends to advisors seeking better investment results.

Bud Haslett, CFA is Head of Risk Management, Derivatives, and Alternative Investments at CFA Institute.

Bud Haslett