In finance,
a credit derivative is a "financial instrument or derivative whose price and value derives from the creditworthiness
of the obligations of a third party, which is isolated and traded."[1]
Credit default products are the most commonly traded credit
derivative product[2]
and include unfunded products such as credit default swaps and funded products such
as synthetic collateralized debt obligations (synthetic CDOs)(see
further discussion below).
Credit derivatives
in their simplest form are bilateral contracts between a buyer
and seller under which the seller sells protection against certain
pre-agreed events occurring in relation to a third party (usually
a corporate or sovereign) known as a reference entity.[3]
These events are called credit events and they relate to the
creditworthiness of the reference entity. The reference entity
will not (except in certain very limited circumstances) be a
party to the credit derivatives contract, and will usually be
unaware of the contract's existence.
The parties
will select which credit events apply to a transaction and these
usually consist of one or more of the following: bankruptcy
(the risk that the reference entity will become bankrupt); failure
to pay (the risk that the reference entity will default on one
of its obligations (e.g. a bond or loan)); obligation default
(the risk that the reference entity will default on any of its
obligations); obligation acceleration (the risk that an obligation
of the reference entity will be accelerated e.g. a bond will
be declared immediately due and payable following a default);
repudiation/moratorium (the risk that the reference entity or
a government will declare a moratorium over the reference entity's
obligations); and restructuring (the risk that obligations of
the reference entity will be restructured).
Where credit
protection is bought and sold between bilateral counterparties
this is known as an unfunded credit derivative. If the credit
derivative is entered into by a financial institution or a special
purpose vehicle and payments under the credit derivative are
funded using securitization techniques, such that a debt obligation
is issued by the financial institution or SPV to support these
obligations, this is known as a funded credit derivative.
This synthetic
securitization process has become increasingly popular over
the last decade, with the simple versions of these structures
being known as synthetic CDOs; credit linked notes; single tranche
CDOs, to name but a few. In funded credit derivatives, transactions
are often rated by rating agencies, which allows investors to
take different slices of credit risk according to their risk
appetite.
Market
size and participants
The ISDA[4] reported in April 2007 that total notional amount on outstanding
credit derivatives was $35.1 trillion with a gross market value
of $948 billion (ISDA's Website).
Although
the credit derivatives market is a global one, Londons market
share rests at about 40 per cent., with the rest value of Europe
standing at about 10 per cent.[2]
The main
market participants are banks, hedge funds, insurance companies,
pension funds, and other corporates. [2]The main inter-dealer brokers are Creditex, Tullett-Prebon,
GFI Group and ICAP.
Types
There are
many types of credit derivatives. Credit derivatives are fundamentally
divided into two categories of product, funded credit derivatives
and unfunded credit derivatives. An unfunded credit derivative
is a bilateral contract between two counterparties, where each
party is responsible for making its payments under the contract
(i.e. payments of premiums and any cash or physical settlement
amount) itself without recourse to other assets. In a funded
credit derivative, the credit derivative will be embedded into
a bond (which will usually either be issued by an SPV or a financial
institution), and bondholders will (ultimately) be responsible
for the payment of any cash or physical settlement amounts.
Unfunded
credit derivative products include the following products:
- Single
name Credit default swap (CDS)
- Total
return swap
- First
to Default Credit Default Swap
- Portfolio
Credit Default Swap
- Secured
Loan Credit Default Swap
- Credit
Default Swap on Asset Backed Securities
- Credit
default swaption (CDS)
- Recovery
lock transaction
- Credit
Spread Option
- CDS index
products
- Constant
Maturid Credit Default Swap (CMCDS)
Funded credit
derivative products include the following products:
- Credit
linked note (CLN)
- Synthetic
Collateralised Debt Obligation (CDO)
- Constant
Proportion Debt Obligation (CPDO)
- Synthetic
Constant Proportion Portfolio Insurance (Synthetic CPPI)
Key
unfunded credit derivative products
Credit
default swap
-
The credit
default swap or CDS has become the cornerstone product of the
credit derivatives market. This product represents over thirty
percent of the credit derivatives market[2].
A credit
default swap, in its simplest form (the unfunded single name
credit default swap) is a bilateral contract between a protection
buyer and a protection seller. The credit default
swap will reference the creditworthiness of a third party called
a reference entity: this will usually be a corporate or sovereign.
The credit default swap will relate to the specified debt obligations
of the reference entity: perhaps its bonds and loans, which
fulfil certain pre-agreed characteristics. The protection buyer
will pay a periodic fee to the protection seller in return for
a contingent payment by the seller upon a credit event
affecting the obligations of the reference entity specified
in the transaction.
The relevant
credit events specfied in a transaction will usually be selected
from amongst the following: the bankruptcy of the reference
entity; its failure to pay in relation to a covered obligation;
it defaulting on an obligation or that obligation being accelerated;
it agreeing to restructure a covered obligation or a repudiation
or moratorium being declared over any covered obligation.
If any of
these events occur and the protection buyer serves a credit
event notice on the protection seller detailing the credit event
as well as (usually) providing some publicly available information
validating this claim, then the transaction will settle.
This means
that, in the case of a physically settled transaction, the protection
buyer can deliver an amount of the reference entity's defaulted
obligations to the protection seller, in return for their full
face value (notwithstanding that they are now worth far less).
In the case of a cash settled transaction, a relevant obligation
of the reference entity will be valued and the protection seller
will pay the protection buyer the full face value of the reference
obligation less its current value (i.e. compensating the protection
buyer for the decline in the obligation's creditworthiness).
Credit default
swaps have unique characteristics that distinguish them from
insurance products and financial guaranties. The protection
buyer does not need to own an underlying obligation of the reference
entity. The protection buyer does not need to suffer a loss.
The protection seller has no recourse to and no right to sue
the reference entity for recovery.
The product
has many variations, including where there is a basket or portfolio
of reference entities, although fundamentally, the principles
remain the same. A powerful recent variation has been gathering
market share of late: credit default swaps which relate to asset-backed
securities or Credit Default Swaps on Asset-Backed Securities"[5].
Total
return swap
-
A total
return swap (also known as Total Rate of Return Swap)
is a contract between two counterparties whereby they swap periodic
payments for the period of the contract. Typically, one party
receives the total return (interest payments plus any capital
gains or losses for the payment period) from a specified reference
asset, while the other receives a specified fixed or floating
cash flow that is not related to the creditworthiness of the
reference asset, as with a vanilla Interest rate swap. The payments
are based upon the same notional amount. The reference asset
may be any asset, index or basket of assets.
The TRS
is simply a mechanism that allows one party to derive the economic
benefit of owning an asset without use of the balance sheet,
and which allows the other to effectively "buy protection" against
loss in value due to ownership of a credit asset.
The essential
difference between a total return swap and a credit
default swap (qv) is that the credit default swap provides
protection against specific credit events. The total return
swap protects against the loss of value irrespective of cause,
whether default, widening of credit spreads or anything else
i.e. it isolates both credit risk and market risk.
Key
funded credit derivative products
Credit
linked notes
In this
example you can see the coupons from the bank's portfolio
of loans is passed to the SPV which uses the cash flow to
service the credit linked notes.
A credit
linked note is a note whose cash flow depends upon an event,
which may be a default, change in credit spread, or rating change.
The definition of the relevant credit events must be negotiated
by the parties to the note.
A CLN in
effect combines a credit-default swap with a regular note (with
coupon, maturity, redemption). Given its note like features,
a CLN is an on-balance-sheet asset, in contrast to a CDS.
Typically,
an investment fund manager will purchase such a note to hedge
against possible down grades, or loan defaults.
Numerous
different types of credit linked notes (CLNs) have been structured
and placed in the past few years. Here we are going to provide
an overview rather than a detailed account of these instruments.
The most
basic CLN consists of a bond, issued by a well-rated borrower,
packaged with a credit default swap on a less creditworthy risk.
For example,
a bank may sell some of its exposure to a particular emerging
country by issuing a bond linked to that country's default or
convertibility risk. From the bank's point of view, this achieves
the purpose of reducing its exposure to that risk, as it will
not need to reimburse all or part of the note if a credit event
occurs. However, from the point of view of investors, the risk
profile is different from that of the bonds issued by the country.
If the bank runs into difficulty, their investments will suffer
even if the country is still performing well.
The credit
rating is improved by using a proportion of government bonds,
which means the CLN investor receives an enhanced coupon.
Through
the use of a credit default swap, the bank receives some recompense
if the reference credit defaults.
There are
several different types of securitized product, which have a
credit dimension. CLN is a generic name related to any bond
whose value is linked to the performance of a reference asset,
or assets. This link may be through the use of a credit derivative,
but does not have to be.
- Credit-linked
notes CLN: Credit-linked note is a generic name related
to any bond whose value is linked to the performance of a
reference asset, or assets. This link may be through the use
of a credit derivative, but does not have to be.
- Collateralized
debt obligation CDO: Generic term for a bond issued
against a mixed pool of assets - There also exists CDO-squared
(CDO^2) where the underlying assets are CDO tranches.
- Collateralized
bond obligations CBO: Bond issued against a pool of
bond assets or other securities. It is referred to in a generic
sense as a CDO
- Collateralized
loan obligations CLO: Bond issued against a pool of
bank loan. It is referred to in a generic sense as a CDO
CDO refers
either to the pool of assets used to support the CLNs or, confusingly,
to the CLNs themselves.
Collateralized
debt obligations (CDO)
-
Collateralized
debt obligations or CDOs are a form of credit derivative offering
exposure to a large number of companies in a single instrument.
This exposure is sold in slices of varying risk or subordination
- each slice is known as a tranche.
In a cashflow
CDO, the underlying credit risks are bonds or loans held by
the issuer. Alternatively in a synthetic CDO, the exposure to
each underlying company is a credit default swap. A synthetic
CDO is also referred to as CSO.
Other more
complicated CDOs have been developed where each underlying credit
risk is itself a CDO tranche. These CDOs are commonly known
as CDOs-squared.
Risks
Risks involving
credit derivatives are a concern among regulators of financial
markets. The US Federal Reserve issued several statements in
the Fall of 2005 about these risks, and highlighted the growing
backlog of confirmations for credit derivatives trades. These
backlogs pose risks to the market (both in theory and in all
likelihood), and they exacerbate other risks in the financial
system. One challenge in regulating these and other derivatives
is that the people who know most about them also typically have
a vested incentive in encouraging their growth and lack of regulation.
(The incentive may be indirect, e.g., academics have not only
consulting incentives, but also incentives in keeping open doors
for research.)
External
links
Independent Source of Credit Derivative
Market Analysis, Data, and Current Events
Notes
and references
