A credit default swap ( CDS ) is a financial swap agreement that sellers of CDS will offset buyers in terms of debt default (by debtors) or other credit events. That is, CDS sellers guarantee buyers against some default reference assets. The CDS buyer makes a set of payment (CDS "fee" or "spread") to the seller and, in return, can expect to receive payment if the asset defaults.
In the event of default, the CDS buyer receives compensation (usually the nominal value of the loan), and the seller of the CDS takes possession of the failed loan or its market value in cash. However, anyone can buy CDS, even buyers who do not hold loan instruments and who have no interest insured directly in the loan (this is called "naked" CDS). If there are more outstanding CDS contracts than existing bonds, there is a protocol for holding a credit event auction. Payments received are often much lower than the nominal value of the loan.
Credit default swaps in their current form have existed since the early 1990s, and increased in use in the early 2000s. By the end of 2007, the remarkable amount of CDS was $ 62.2 trillion, down to $ 26.3 trillion by mid-2010 and reported $ 25.5 trillion in early 2012. CDS is not traded on the exchange and no transaction reporting required for a government agency. During the 2007-2010 financial crisis the lack of transparency in this large market became a concern for regulators as it may pose a systemic risk. In March 2010, Depository Trust & amp; Clearing Corporation (see Market Data Sources) announces it will give regulators greater access to its default credit swaps database.
CDS data can be used by financial professionals, regulators, and media to monitor how the market perceives credit risks from every entity on which CDS is available, comparable to those provided by Credit Rating Agencies. The US court will soon follow suit.
Most CDSs are documented using a standard form compiled by the International Swap and Derivatives Association (ISDA), although there are many variants. In addition to basic swaps, single names, there are default swap bins (BDSs), CDS indexes, funded CDS (also called credit-linked notes), as well as credit-only swaps (LCDS) default credit. In addition to companies and governments, reference entities may include special purpose vehicles that issue asset-backed securities.
Some claim that derivatives such as CDS are potentially dangerous because they combine priorities in bankruptcy with a lack of transparency. CDS can be unsecured (no collateral) and at higher risk for default.
Video Credit default swap
Description
CDS is associated with a "reference entity" or "reference", usually a company or a government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amount is the "spread" charged by the seller to insure against the credit event. If the default reference entity, the seller's protection pays the buyer the face value of the bond in exchange for physical delivery of the bond, although the settlement may also be by cash or auction.
Defaults are often referred to as "credit events" and include events such as failure to pay, restructuring and bankruptcy, or even a downgraded credit rating of the borrower. CDS contracts on sovereign obligations are also usually included as a refusal, moratorium and acceleration of credit activities. Most CDS are in the range of $ 10- $ 20 million with a period of between one and 10 years. Five years is the most distinctive maturity.
Investors or speculators may "buy protection" to protect the risk of default on bonds or other debt instruments, regardless of whether the investor or speculator holds interest or assumes the risk of loss associated with the bond or debt instrument. In this way, CDS is similar to credit insurance, although CDS is not subject to the rules governing traditional insurance. In addition, investors can buy and sell protection without having debts from the reference entity. "Unauthorized transfer of credit default" allows traders to speculate about the creditworthiness of the reference entity. CDS can be used to create long, synthetic short positions in reference entities. The Naked CDS is the majority of the market in CDS. In addition, CDS can also be used in capital structure arbitration.
A "credit default swap" (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return will receive a payment if the underlying financial instrument fails or experiences a similar credit event. CDS may refer to a particular bond or bond loan from a "reference entity", usually a company or a government.
For example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. Investor - buyer protection - will make regular payments to AAA-Bank - seller of protection. If Risky Corp fails to pay its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated.
If the investor actually owns Risky Corp's debt (that is, owed money by Risky Corp), CDS can act as a hedge. But investors can also buy CDS contracts that reference Risky Corp's debt without actually having Risky Corp's debt. This may be done for speculative purposes, betting against Risky Corp's solvency in betting to make money, or to protect investments in other companies whose fate is expected to resemble Risky Corp (see Usage).
If the reference entity (ie, Risky Corp) defaults, one of two types of settlement may occur:
- The investor sends the failed asset to the Bank for the payment of the nominal value, known as the physical settlement ; AAA-Bank pays investors the difference between the nominal value and the market price of a specified debt obligation (even if the Risky Corp's default usually has some recovery , that is, not all investors' money is lost), known as cash payment .
The "deployment" of CDS is the annual number of buyer's protection must pay the seller protection during the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then the investor who buys a $ 10 million protection from AAA-Bank must pay $ 50,000 to the bank. Payments are usually made every three months, in arrears. This payment continues until the CDS contract expires or the default Risky Corp.
All things considered equal, at any given time, if the maturity of two credit default swaps are equal, then the CDS associated with the company with higher CDS spread is considered more likely to be defaulted by market, as higher costs are being charged to protect against this happening. However, factors such as liquidity and estimated losses given by default can affect the comparison. The degree of credit distribution and credit rating of the underlying or reference obligations is considered among the money managers to be the best indicator of the possibility of CDS sellers having to perform under this contract.
Differences from insurance
CDS contracts have a clear similarity with insurance, because the buyer pays the premium and, in return, receives some money in case of a bad event.
However, there are also many differences, the most important being that the insurance contract provides compensation for losses that are actually suffered by the policyholder on an asset in which he has an insurable interest. In contrast, CDS provides the same payout for all holders, calculated using approved methods across markets. The holder does not need to have the underlying security and does not even have to suffer a loss from the default event. Therefore CDS can be used to speculate about debt objects.
Other differences include:
- The seller may in principle not be a regulated entity (although in practice most banks are);
- The seller is not required to retain reserves to protect the protection being sold (this is the main cause of AIG's financial difficulties in 2008; does not have sufficient reserves to meet the expected "run" payments caused by the collapse of housing bubbles);
- Insurance requires buyers to disclose all known risks, while CDS does not (CDS sellers in most cases can still determine potential risks, since "insured" debt instruments are market commodities available for inspection, but in this case certain instruments CDO consisting of a "slice" of debt packages, it may be difficult to know exactly what is insured);
- Insurers manage risks primarily by setting a reserve for losses under a large number Act and actuarial analysis. Dealers in CDS manage risk primarily by hedging with other CDS transactions and on the underlying bond market;
- CDS contracts are generally subject to mark-to-market accounting, introducing profit and loss statements and balance sheet volatility while insurance contracts are not;
- Hedging accounting may not be available under Generally Accepted Accounting Principles (GAAP) unless FAS 133 requirements are met. In practice this is rare.
- to cancel the insurance contract the buyer can usually stop paying the premium, while for the CDS the contract must be canceled.
Risk
When inserting into a CDS, both buyer and seller of credit protection take counterparty risks:
- Buyers are taking risks that sellers may default. If AAA-Bank and Risky Corp defaults simultaneously ("double defaults"), the buyer loses protection against defaults by the reference entity. If AAA-Bank's default but Risky Corp. No, buyers may need to replace a failed CD at a higher cost.
- The seller takes the risk that the buyer may fail on the contract, robs the expected revenue stream seller. More importantly, the seller usually limits the risk by purchasing offsetting protection from other parties - that is, protecting its exposure hedges. If the original buyer leaves, the seller compresses his position by loosening the hedging transaction or by selling the new CDS to a third party. Depending on market conditions, it may be priced lower than the original CDS and therefore may cause harm to the seller.
In the future, in the case of regulatory reforms requiring CDS to be traded and resolved through the clearing house, such as ICE TCC, there will be no counterparty risk, since the counterparty risk will be held with a clearing house.
As with other forms of over-the-counter derivatives, CDS may involve liquidity risk. If one or both parties in the CDS contract must post the collateral (which is common), there may be margin calls requiring additional warranty posting. The warranty requested is approved by the parties when the CDS is first published. The amount of this margin may vary during the term of the CDS contract, if the market price of the CDS contract changes, or the credit rating of either party changes. Many CDS contracts even require payment of upfront fees (consisting of "reset to par" and "initial coupon.").
Another type of risk for sellers of credit default swaps is the risk of jumps or the jump-to-default risk. CDS sellers can collect monthly premiums with little hope that reference entities can default. A default creates a sudden liability on the seller's protection to pay millions, if not billions, of dollars for buyer protection. This risk does not exist in other over-the-counter derivatives.
Market data source
Data on the credit default swap market is available from three main sources. Annual and semi-annual data are available from the International Swap and Derivatives Association (ISDA) since 2001 and from the Bank for International Settlements (BIS) since 2004. The Depository Trust & Clearing Corporation (DTCC), through the global storage of Trade Information Warehouse (TIW), provides weekly data but publicly available information only returns a year. The numbers provided by each source do not always match because each provider uses a different sampling method. Daily, intraday and real time data is available from S & amp; P Capital IQ through their acquisition of Credit Market Analysis in 2012.
According to the DTCC, Trade Information Warehouse maintains the only "global electronic database for virtually all CDS contracts on the market."
The Currency Finance Supervisory Office publishes quarterly credit derivatives data on US insured commercial banks and trust companies.
Maps Credit default swap
Usage
Credit default swaps can be used by investors for speculation, hedging and arbitration.
Speculation
Credit default swaps allow investors to speculate on changes in CDS deployment from a single name or market index such as the North American CDX index or the European iTraxx index. An investor may believe that the entity's CDS spread is too high or too low, relative to the entity's bond yields, and seeks to take advantage of that view by entering trade, known as trading base, which combines CDS with cash bonds and interest rate swaps.
Finally, an investor may speculate about the entity's credit quality, as it generally spreads when credit worthiness decreases, and decreases as creditworthiness increases. Therefore, investors may purchase CDS protection at the company to speculate that it will fail. Alternatively, the investor may sell the protection if it thinks that the creditworthiness of the company can increase. Investors who sell CDS are viewed as "old" on CDS and credit, as if investors have bonds. Instead, investors are buying "short" protection on CDS and underlying credit.
Credit default swap opens up new avenues important to speculators. Investors can extend the bonds without any upfront costs to buy bonds; all that an investor needs to do is a promise to pay in case of a default. Shortening ties to difficult practical problems, so shorting is often not feasible; CDS shorten credit and popular. Since the speculators in both cases do not have a bond, its position is said to be a long or synthetic short position.
For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, he bought a $ 10 million CDS protection for two years from AAA-Bank, with Risky Corp as reference entity, with a spread of 500 basis points (= 5%) per year. If Risky Corp's default after, say, a year, the hedge fund will pay $ 500,000 to AAA-Bank, but then receive $ 10 million (assuming a zero recovery rate, and that AAA-Bank has liquidity to cover losses), resulting in a profit. AAA-Bank, and its investors, will experience a $ 9.5 million loss minus recovery unless the bank has changed its position before default.
Note that there is a third possibility in the above scenario; hedge funds may decide to liquidate their positions after a certain period of time in an attempt to realize their gains or losses. As an example:
- After 1 year, the market now considers Risky Corp more likely to default, so its CDS spreads have widened from 500 to 1500 basis points. Hedge funds may choose to sell $ 10 million of 1 year protection to AAA-Bank at this higher rate. Therefore, for two years, hedge funds pay the bank 2 * 5% * $ 10 million = $ 1 million, but receive 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 likely to be less likely to default, so its CDS spread has been tightened from 500 to 250 basis points. Again, hedge funds may choose to sell $ 10 million of 1 year protection to AAA-Bank on this lower spread. Therefore, for two years, hedge funds pay the bank 2 * 5% * $ 10 million = $ 1 million, but receive 1 * 2.5% * $ 10 million = $ 250,000, resulting in a total loss of $ 750,000. This loss is less than the $ 1 million loss that would have happened if the second transaction had not been made.
Transactions like this do not even have to be put into the long run. If Risky Corp's CDS spread has widened by just a few basis points over the course of a single day, hedge funds could have entered into an offsetting contract immediately and made a small profit over the lifetime of two CDS contracts.
Credit default swaps are also used to structure debt syndicated debt (CDOs). Instead of having a bond or loan, synthetic CDO gets credit exposure to a fixed income asset portfolio without owning such assets through the use of CDS. CDO is seen as a complex and opaque financial instrument. An example of a synthetic CDO is the Abacus 2007-AC1, which is the subject of a fraud lawsuit filed by the SEC against Goldman Sachs in April 2010. Abacus is a synthetic CDO consisting of credit default swaps that refer to mortgage-backed securities.
Native credit swap
In the above example, hedge funds do not have Risky Corp's debt. A CDS in which the buyer has no underlying debt is referred to as bare credit default swap , estimated at up to 80% of the credit default swap market. There is currently debate in the United States and Europe on whether the speculative use of credit default swaps should be banned. Legislation is being considered by Congress as part of financial reform.
Critics insist that bare CDS should be banned, comparing it with buying fire insurance at your neighbor's house, which creates a huge incentive for burning. By analizing the concept of insurable interest, critics say you should not be able to buy CDS - insurance against default - when you do not have a bond. Short selling is also seen as gambling and CDS markets as casinos. Another concern is the size of the CDS market. Since the default swap credit default is synthetic, there is no limit to how much it can sell. The gross amount of CDS far exceeds all "real" corporate bonds and outstanding loans. As a result, the risk of default is magnified which causes concerns about systemic risks.
Investor George Soros called for a direct ban on default credit barred swaps, viewing them as "toxic" and allowing bets to fight against and "invade" the company or country. His concerns were repeated by some European politicians who, during the Greek Financial Crisis, accused naked CDS buyers of making the crisis worse.
Despite these concerns, Treasury Secretary Geithner and Chairman of the Gensler Commodity Futures Trading Commission do not support a direct ban on default credit barred swaps. They prefer transparency and better capitalization requirements. These officials think that bare CDS has a place in the market.
Advocates of credit default swaps say that short selling in various forms, whether credit default swaps, options or futures, has a beneficial effect of increasing liquidity in the market. It benefits the hedging activity. Without speculators buying and selling CDS naked, the bank that wants to hedge may not find a ready-made protection vendor. Speculators also create more competitive markets, keeping prices down for hedger. A strong market in credit default swaps can also serve as a barometer for regulators and investors about the creditworthiness of companies or countries.
Despite claims that speculators are making the Greek crisis worse, German market regulator BaFin found no evidence to support the claim. Some suggest that without credit default swaps, Greece's borrowing costs will be higher. In November 2011, Greek bonds had a bond yield of 28%.
A bill in the US Congress proposes granting public authority the power to limit the use of CDS in addition to hedging purposes, but the bill does not become a law.
Hedging
Credit default swaps are often used to manage default risks arising from holding debt. A bank, for example, may protect the risk that a borrower may fail to repay a loan by entering into a CDS contract as a protection buyer. If the loan fails, the outcome of the CDS contract cancels a loss on the underlying debt.
There are other ways to eliminate or reduce the risk of default. The bank may sell (ie, assign) the loan directly or bring in another bank as a participant. However, these options may not meet the needs of the bank. Approval from corporate borrowers is often required. Banks may not want to spend the time and expense to find loan participants.
If renowned borrowers and lenders and markets (or even worse, news media) know that banks sell loans, then sales can be seen as signifying a lack of trust in the borrower, which can be very detrimental. damaging the banker-client relationship. In addition, banks may not want to sell or share the potential benefits of the loan. By purchasing a credit default swap, banks can lay off default risks while maintaining loans in their portfolios. The downside to this protection is that without risk of default, the bank may not have the motivation to actively monitor the loan and the partner has no relationship with the borrower.
Another type of hedge is against the risk of concentration. The bank's risk management team can suggest that the bank is too centered on a particular borrower or industry. Banks may terminate some of this risk by purchasing CDS. Because the borrower - a reference entity - is not a party to a congenital credit exchange, entering a CDS allows the bank to achieve its diversity objectives without affecting its loan portfolio or its customer relationships. Similarly, a bank that sells CDS can diversify its portfolio by gaining exposure to an industry where the sales bank has no customer base.
Protection of bank purchases may also use CDS to release regulatory capital. By applying certain credit risks, banks are not required to have as much capital as possible against defaults (usually 8% of total loans under Basel I). This frees resources that can be used by banks to provide other loans to the same primary customers or to other borrowers.
The risk of hedging is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds, or insurance companies, may purchase CDS as a hedge for similar reasons. Examples of pension funds: The pension fund has a five-year bond issued by Risky Corp with a nominal value of $ 10 million. To manage the risk of losing money if Risky Corp fails to pay its debts, the pension fund purchases CDS from Derivative Bank in a notional amount of $ 10 million. Trading CDS on 200 basis points (200 basis points = 2.00 percent). In return for this credit protection, pension funds pay 2% of $ 10 million ($ 200,000) per annum in quarterly installments of $ 50,000 to Derivatives Bank.
- If Risky Corporation fails to pay its bonds, the pension funds make quarterly payments to the Derivative Bank for 5 years and receive $ 10 million back after five years from Risky Corp. Although protection payments totaling $ 1 million reduced the return on investment for pension funds, the risk of losses due to Risky Corp failing on the bonds was abolished.
- If Risky Corporation fails to pay its three-year debt into the CDS contract, the pension fund will stop paying quarterly premiums, and the Derivatives Bank will ensure that the pension fund is returned for a $ 10 million loss minus the recovery (either by physical settlement or cash - see Settlement under). The pension fund still lost $ 600,000 that had been paid for three years, but without the CDS contract it would lose all $ 10 million less recovery.
In addition to financial institutions, large suppliers may use default credit swaps on public bond issues or similar basket of risks as proxies for their own credit risk exposures on receivables.
Although credit default swaps have been heavily criticized for their role in the recent financial crisis, most observers conclude that using credit default swaps as hedging devices has a worthwhile purpose.
Arbitrage
Arbitrage Capital Structure is an example of an arbitration strategy that uses CDS transactions. This technique depends on the fact that the company's stock price and its CDS spread must show a negative correlation; that is, if the prospects for a company increase then the stock price will rise and the spread of the CDS should be tightened, as it is less likely to default on the debt. However, if the outlook worsens then its CDS spread should widen and its share price will go down.
This dependent technique is known as the arbitrage capital structure because they exploit market inefficiencies between different parts of the same corporate capital structure; eg, the price of debt and corporate equity. An arbitrage tries 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 stock price has dropped 25%, but its CDS spread remains unchanged, then investors may expect CDS spread to increase relative to stock prices. Therefore, the basic strategy will be long on CDS deployment (by purchasing CDS protection) while simultaneously protecting themselves by purchasing the underlying stock. This technique would be advantageous if the spread of CDS widened relative to the equity price, but would lose money if the company's CDS spreads strictly to its equity.
An interesting situation where the inverse correlation between the company's stock price and CDS spreads is broken during Leveraged Buyout (LBO). Often this causes the company's CDS to spread wider because of the additional debt that will soon be included in the company's books, but also the increase in stock prices, since corporate buyers usually end up paying a premium.
Another general arbitrage strategy aims to exploit the fact that spread-adjusted spreads of CDS must trade closely with the underlying cash bonds issued by the reference entity. Alignment in deployment may occur due to technical reasons such as:
- Specific residential differences
- Disadvantages in certain basic instruments
- Funding cost of position
- The presence of buyers is constrained from buying exotic derivatives.
The difference between a CDS spread and an asset spread spread is called base and should theoretically approach zero. Basic trade can aim to exploit any discrepancies to make risk-free profits.
History
Conception
The form of credit default swaps has existed since the early 1990s, with early trading conducted by the Bankers Trust in 1991. J.P. Morgan & amp; Co. is widely credited with creating modern standard credit exchanges in 1994. In that example, J.P. Morgan has extended its $ 4.8 billion credit line to Exxon, which faces a $ 5 billion threat in punitive damages for the Exxon Valdez oil spill. A team of JP Morgan bankers led by Blythe Masters then sells credit risk from the credit line to the European Reconstruction and Development Bank to cut the reserves that JP Morgan has to withstand Exxon's negligence, raising its own balance sheet..
In 1997, JPMorgan developed a proprietary product called BISTRO (Broad Index Securitized Trust Offering) that uses CDS to clean bank balance sheets. The advantage of BISTRO is that it uses securitization to divide credit risk into small parts that are easier to find by small investors, as most investors do not have the EBRD's ability to receive $ 4.8 billion in credit risk at once. BISTRO is the first example of what came to be known as synthetic debt obligations (CDO).
Given the concentration of default risk as one of the causes of the S & amp; L, the regulator initially found the ability of CDS to dissolve the attractive default risk. In 2000, credit default swaps were greatly exempted from regulations by the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The Modernization Act of Futures Commodity of 2000, which is also responsible for Enron's gap, specifically states that CDS is not futures or securities and so is beyond sending SEC and CFTC.
Market growth
Initially, banks were the dominant players in the market, as CDS was primarily used to protect risks in relation to their lending activities. The Bank also sees opportunities to free regulatory capital. In March 1998, the global market for CDS was estimated at about $ 300 billion, with JP Morgan alone reaching about $ 50 billion.
The high market share enjoyed by banks is immediately eroded as more asset managers and hedge funds see trading opportunities in credit default swaps. In 2002, investors as speculators, not banks as hedger, dominate the market. The national bank in the US used credit default swaps in early 1996. That year, the Office of Financial Supervisors measured the market size as tens of billions of dollars. Six years later, at the end of 2002, the outstanding amount was more than $ 2 trillion.
Although speculators trigger exponential growth, other factors also play a role. Expanded markets could not emerge until 1999, when ISDA standardized documentation for credit default swaps. Also, the 1997 Asian Financial Crisis spurred the market for CDS in emerging-market debt. In addition, in 2004, index trading started on a large scale and expanded rapidly.
The market size for Credit Default Swap 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 the notional figure decreased during 2008 as a result of the dealer's "compression portfolio" (redundant contract), and by the end of 2008 the number of outstanding notes had dropped 38 percent to $ 38.6 trillion.
Explosive growth is not without operational headaches. On September 15, 2005, the New York Fed called 14 banks to its offices. Billions of dollars of CDS are traded on a daily basis but records are for more than two weeks. This creates a severe risk management problem, as opposing parties are within legal and financial constraints. The British authorities expressed the same concern.
Market in 2008
Because default is a relatively rare occurrence (historically about 0.2% of the company's default investment grade in one year), in most CDS contracts payments are only premium payments from buyers to sellers. Thus, although the above figures for exceptional notional are enormous, in the absence of default net cash flows are only a fraction of this total: for a 100 bp = 1% spread, the annual cash flow is only 1% of the notional amount.
Regulatory worries over CDS
The market for Credit Default Swaps drew much attention from regulators after a number of large-scale incidents in 2008, beginning with the fall of Bear Stearns.
In the days and weeks leading up to the collapse of Bear, bank CDS spreads dramatically, signaling a surge in buyers taking refuge in banks. It is thought that this widening is responsible for the perception that Bear Stearns is vulnerable, and therefore limits its access to wholesale capital, leading eventually to forced sales to JP Morgan in March. An alternative view is that this buyer's surge in CDS protection is a symptom rather than the cause fall of Bear; ie, investors see that Bear is in trouble, and trying to hedge a bare exposure to a bank, or speculate about its collapse.
In September, the bankruptcy of Lehman Brothers caused a total close to $ 400 billion to be paid to purchasers of CDS protection referenced against insolvent banks. But the net amount that changed hands was about $ 7.2 billion. (The quotation does not support one of the two facts mentioned in the previous two sentences.). This difference is caused by the 'net' process. Market participants work together so that CDS sellers are allowed to deduct from their payment of incoming funds as they are from their hedging positions. Dealers are generally trying to stay neutral against risk, so their losses and profits after a big event offset each other.
Also in September the American International Group (AIG) needs a $ 85 billion federal loan for over-selling the CDS protection without hedging the possibility that the reference entity might decline in value, exposing the insurance giant to a potential loss of more than $ 100 billion. CDS on Lehman settled smoothly, as in most cases for 11 other credit events that occurred in 2008 that triggered payments. And while it can be argued that other incidents will be worse or worse if less efficient instruments than CDS have been used for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risks involved in CDS transactions.
In 2008 there was no centralized exchange or clearing house for CDS transactions; they are all done on the table (OTC). This has led to new appeals for the market to be open in terms of transparency and regulation.
In November 2008, Depository Trust & amp; Clearing Corporation (DTCC), which runs a warehouse for CDS trade confirmation that controls about 90% of the total market, announces that it will release market data on a remarkable CDS trade notional every week. Data can be accessed on the DTCC website here:
In 2010, the Intercontinental Exchange, through its subsidiary ICE Trust in New York, launched in 2008, and ICE Clear Europe Limited in London, UK, launched in July 2009, the clearing entity for credit default swaps (CDS) has cleared more of $ 10 trillion in credit default swaps (CDS) (Terhune Bloomberg Business Week 2010-07-29). Bloomberg's Terhune (2010) describes how investors seek high margin returns using Credit Default Swaps (CDS) to bet against financial instruments held by companies and other countries. Intercontinental clearing houses guarantee every transaction between buyer and seller provides a much-needed safety net to reduce the impact of failure by spreading the risk. ICE collects on every trade. (Terhune Bloomberg Business Week 2010-07-29). However, Brookings senior research fellow Robert E. Litan warned, "valuable pricing data will not be fully reported, leaving ICE institutional partners with huge information gains compared to other traders, calling the ICE Trust" derivative dealer club "where members make money at the expense of nonmembers (Terhune quotes Litan in Bloomberg Business Week 2010-07-29). "Litan admitted that" some limited progress towards cleaning CDS centers has been made in recent months, with CDS contracts between dealers now being cleaned centrally primarily through a clearinghouse (ICE Trust) where dealers have significant financial interest (Litan 2010.): "However," as long as the ICE Trust has a monopoly in clearing, consider the dealer for limit the expansion of centrally cleaned products, and to create barriers to trade elek tronik and smaller dealers make the market competitive in products that have been cleaned (Litan 2010: 8). "
In 2009, the US Securities and Commerce Commission granted an exemption for the Intercontinental Exchange to begin guaranteeing credit-default swaps. The SEC exception is the latest regulatory approval required by the Intercontinental Atlanta. A derivative analyst at Morgan Stanley, one of supporters for the IntercontinentalExchange subsidiary, ICE Trust in New York, launched in 2008, claimed that "clearinghouses, and contract changes to standardize them, might increase activity". The subsidiary of IntercontinentalExchange, a larger ICE Trust competitor, CME Group Inc., has not received the SEC's release, and agency spokesman John Nester said he did not know when the decision would be made.
Market in 2009
The early months of 2009 saw some fundamental changes to the way CDS operates, resulting from concerns over the safety of instruments after the events of the previous year. According to Deutsche Bank managing director, Athanassios Diplas, "industry is pushing change for 10 years in just a few months". At the end of 2008 the process has been introduced enabling CDS that mutually offset to be canceled. Along with the recently terminated contract termination as based on Lehmans, this in March reduced the nominal value of the market down to about $ 30 trillion.
The Bank for International Settlements estimates that outstanding derivatives reach $ 708 trillion. The US and European regulators are developing separate plans to stabilize the derivatives market. In addition there are several globally agreed standards adopted in March 2009, administered by the International Swap and Derivatives Association (ISDA). The two main changes are:
1. Introduction of central clearing house, one for US and one for Europe. Clearing house acts as a central counterparty for both sides of CDS transactions, thereby reducing counterparty risks faced by both buyers and sellers.
2. International standardization of CDS contracts, to prevent legal disputes in ambiguous cases where payments should be unclear.
Speaking before the change took place, Sivan Mahadevan, a derivatives analyst at Morgan Stanley, one of supporters for the IntercontinentalExchange subsidiary, ICE Trust in New York, launched in 2008, claiming that
In the US, the central clearing operation began in March 2009, operated by the InterContinental Exchange (ICE). The main competitor who is also interested in entering the CDS clearing sector is the CME Group.
In Europe, CDS Index clearing was launched by the European subsidiary of IntercontinentalExchange ICE Clear Europe on July 31, 2009. The company launched the Sole Name Cleanup in December 2009. At the end of 2009, they have completed CDS contracts worth EUR 885 billion which reduced open interest rates down to EUR 75 billion
By the end of 2009, banks have reclaimed most of their market share; hedge funds mostly withdrew from the market after the crisis. According to estimates by Banque de France, at the end of 2009 JP Morgan's own bank now has about 30% of the global CDS market.
Government approval of ICE and rivals CME
The SEC's approval of ICE Futures' request to exempt from regulations that would prevent it from clearing the CDS is a third government action given to the Intercontinental within a week. On March 3, the acquisition plan of Clearing Corp., a Chicago clearinghouse belonging to the eight largest dealers in the credit-default swap market, was approved by the Federal Trade Commission and the Department of Justice. On March 5, 2009, the Federal Reserve Board, which oversees the clearinghouse, granted ICE's request to start clearing.
Cleaning up the shareholders of the Corp including JPMorgan Chase & amp; Co., Goldman Sachs Group Inc. and UBS AG, received $ 39 million in cash from Intercontinental in the acquisition, as well as Clearing Corp. cash on hand and a 50-50 profit sharing agreement with Intercontinental on revenues generated from swap processing.
SEC spokesman John Nestor stated
Other proposals for removing credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Only NYSE efforts are available now for clearing after starting on December 22nd. On January 30th, no swaps have been deleted. by London-based NYSE derivative exchanges, according to NYSE Chief Executive Officer Duncan Niederauer.
Requirements to clean up house members
Intercontinental ICE Trust (ICE Clear Credit) members in March 2009 must have a net worth of at least $ 5 billion and A or better credit ratings to eliminate their standard credit swap trade. Intercontinental said in a statement today that all market participants such as hedge funds, banks or other institutions are open to becoming clearinghouse members as long as they meet these requirements.
Clearinghouse acts as a buyer for each seller and seller to each buyer, reducing the risk of a counterparty default on a transaction. In an over-the-counter market, where credit-default swaps are currently traded, participants are exposed to each other in default. Clearinghouse also provides a location for regulators to see traders' positions and prices.
J.P. Morgan's loss
In April 2012, people in hedge funds become aware that the market in credit default swaps may be affected by Bruno Iksil's activities, traders for J.P. Morgan Chase & amp; Co., referred to as the "London whale" refers to the great position he takes. The heavy bets that are opposed to his position are known to have been performed by the merchants, including other branches of J.P. Morgan, which buys the derivatives offered by J.P. Morgan in high volume. Big losses, $ 2 billion, were reported by the company in May 2012 in connection with this trade. The disclosure, which generated headlines in the media, did not reveal the exact nature of the trade involved, which is still in process. Traded items, possibly related to CDX IG 9, index based on default risks from major US companies, have been described as "derivatives of a derivative".
Typical CDS contract terms
CDS contracts are usually documented under the confirmation which refers to the definition of credit derivatives published by the International Swap and Derivatives Association. Confirmation usually determines a reference body , a company or sovereignty that generally, though not always, has outstanding debt, and a reference liability , usually corporate bonds or non-biodegradable government bonds. The period in which the default protection is expanded is determined by the effective effective date and scheduled termination date.
This confirmation also specifies the calculator agent responsible for making decisions regarding successor and substitute reference liability (eg required if the original reference obligation is a paid loan before the expiration of the contract), and to perform various calculations and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, dealers are generally a calculation agent, and in contracts between CDS dealers, the seller of protection is generally a calculation agent.
It is not the responsibility of the calculating agency to determine whether a credit event has occurred but rather the fact that, in accordance with the provisions of a typical contract, must be supported by publicly available information submitted along with a credit event notification . A typical CDS contract does not provide an internal mechanism to challenge the occurrence or absence of a credit event and it is better to hand the matter to court if necessary, even though the actual occurrence of certain disputed events is relatively rare.
The CDS confirmation also determines the credit event which will result in payment obligations by the seller's protection and the shipping obligations by the buyer's protection. Typical credit events include bankruptcy in respect of the reference entity and failure to pay in connection with the immediate bond or loan or loan guarantee. CDSs written in North American investment-grade entity reference entities, European corporate reference entities, and authorities generally also include restructuring as credit events, whereas trade referring to high-end North American reference firms is usually not.
Finally, the standard CDS contract specifies the characterized liability submitted that limits the range of liabilities that shoppers may protect on credit events. Trade conventions for the characteristics of submitted obligations vary for different markets and types of CDS contracts. Typical limitations include that the debt may be transferred to a bond or loan, which has a maximum 30-year maturity, which is not subordinated, that it is not subject to transfer restrictions (other than Rule 144A), that it is a standard currency and that it is not subject to some possibilities before maturity.
Premium payments are generally quarterly, with due dates (as well as premium payment dates) falling on March 20, June 20, September 20, and December 20. Due to its proximity to the date of IMM, which falls on the third Wednesday of these months, the CDS maturity date is also referred to as "IMM date".
Credit default swap and state debt crisis
Credit default swap and credit default swapThe European sovereign debt crisis results from a combination of complex factors, including financial globalization; easy credit conditions during the period 2002-2008 that encouraged high lending and lending practices; the global financial crisis 2007-2012; imbalance of international trade; an exploding real estate bubble; global recession 2008-2012; fiscal policy options related to government revenues and expenditures; and the approach used by the state to save troubled banking industry and private bond holders, assuming private debt burden or socialization losses. The credit default swap market also reveals the beginning of a sovereign crisis.
Since December 1, 2011 the European Parliament has banned naked credit default swaps (CDS) on debt to sovereign nations.
The definition of restructuring is technical enough but it is basically meant to respond to the circumstances in which a reference entity, as a result of its credit decline, negotiates changes in terms of its debts with its creditors as an alternative to formal insolvency proceedings (ie, debt restructured). During the Greek debt crisis of 2012, an important issue is whether restructuring will trigger credit default swap (CDS) payments. The European Central Bank and the International Monetary Fund negotiator have avoided these triggers because they could jeopardize the stability of the major European banks that have become writers of protection. Another alternative is to make a new CDS that will obviously pay in terms of debt restructuring. The market will pay the difference between this and the old (potentially more ambiguous) CDS. This practice is far more typical in jurisdictions that do not provide protection status to a bankrupt debtor similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising from the Conseco restructuring in 2000 led to the abolition of credit events from North America's high-yield trade.
Settlement
Physical or cash
As explained in the previous section, if a credit event occurs the CDS contract can be settled physically or cash settled .
- Physical settlement: The seller of protection pays the buyer's nominal value, and in return takes delivery of the debt obligations of the reference entity. For example, hedge funds have purchased $ 5 million in protection from banks over senior corporate debt. In the event of default, the bank pays hedge funds hedge funds, and hedge funds must provide $ 5 million in the face value of the company's senior debt (usually bonds or loans, which is usually very small given that the company is in default).
- Cash settlement: Seller's protection pays the buyer the difference between the face value and market price of the debt obligations of the reference entity. For example, hedge funds have purchased $ 5 million in protection from banks over senior corporate debt. The company has now failed, and its senior bond is now trading at 25 (ie, 25 cents on the dollar) as the market believes that senior bondholders will receive 25% of the money they have after the company ends. Therefore, the bank must pay a hedge fund of $ 5 million (100% -25%) = $ 3.75 million.
The development and growth of the CDS market means that in many companies there is now a much larger CDS contract notation than the remarkable notional value of its debt obligations. (This is because many parties make CDS contracts for speculative purposes, without actually having the debt they want guaranteed for default). For example, at that time filing for bankruptcy on September 14, 2008, Lehman Brothers had about $ 155 billion in outstanding debt but about $ 400 billion of CDS contract notional value has been written which referenced this debt. Obviously not all of these contracts can be settled physically, as there is no Lehman Brothers debt sufficiently extraordinary to fulfill all contracts, indicating the need for CDS cash trading. Confirmation of trades generated when a CDS is traded states whether the contract should be physically or cash settled.
Auction
When a credit event occurs in a large company where many CDS contracts are written, an auction (also known as a credit setting event) may be held to facilitate the settlement of a large number of contracts at the same time, at a fixed cash settlement price. During the auction process, participating dealers (eg, large investment banks) propose the price at which they will buy and sell the obligations of the reference entity's debt, as well as the net demand for a nominal physical settlement. The second auction of the Netherlands is held after the initial publication of the mid-point of the dealer market and what net interest is open for delivering or delivering real bonds or loans. The final clearing point of this auction sets the final price for the cash settlement of all CDS contracts and all physical settlement requests and the corresponding bidding offer generated from the auction are actually completed. According to the International Association of Swap and Derivatives (ISDA), which governs it, recent auctions have proved an effective way to complete the enormous volume of outstanding CDS contracts written on companies like Lehman Brothers and Washington Mutual. Commentator Felix Salmon, however, has questioned earlier the ability of the ISDA to draw up auctions, as defined to date, to determine the compensation associated with the 2012 bond swap in Greek government debt. For its part, the ISDA in the lead to 50% or more "haircuts" for the Greek bondholder, expressed the opinion that the bond swap will not be a default event.
Below is a list of auctions that have been held since 2005.
Pricing and valuation
There are two competing theories usually advancing for credit default swap pricing. The first, referred to here as the 'probability model', takes the present value of a series of cash flows weighed by their non-default probabilities. This method indicates that credit default swaps should be traded at a much lower spread than corporate bonds.
The second model, proposed by Darrell Duffie, but also by John Hull and Alan White, uses an arbitrary approach.
Probability model
Under the probability model, credit default swaps are rewarded using a model that takes four inputs; this is similar to the rNPV model (risk-adjusted NPV) used in drug development:
- "premium issues",
- recovery rate (notional payout percentage in case of default),
- "credit curve" for the reference entity and
- "LIBOR curve".
If the default event never happens, the CDS price is just the amount of discounted premium payment. Thus the CDS pricing model should consider the possibility of default occurring some time between the effective date and the due date of the CDS contract. For explanation purposes, we can imagine a one year CDS case with an effective date with four quarterly premium payments that occurred at , , , and . If the nominal for CDS is and the problem premium is then the quarterly premium payment size is . If we assume for the simplicity that a default can only happen on one of the payment dates then there are five ways the contract could expire:
- either it has no default at all, so four premium payments are made and the contract lasts until the due date, or
- default occurs on the first, second, third or fourth payment date.
To set the price of CDS, we now need to set the probability to five possible results, then calculate the present value of the result for each result. The present value of the CDS then only the present value of the five prizes multiplied by the probability that occurs.
This is illustrated in the following tree diagram where on each payment date both contracts have a default event, in which case it ends with a payment of is shown in red, where is the recovery rate, or persisted without a standard trigger, in this case premium payment created, displayed in blue. On both sides of the diagram is cash flow up to that point with a premium payment with a blue payment and a default payment in red. If the contract ends the square shown with solid shading.
Probabilitas bertahan selama interval
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