Credit derivatives – Finance and Banking


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This practice note focuses on credit default swaps (CDS) (both single name and index) and provides a high level overview of how they work, with particular emphasis on corporate CDS. Although the product may seem relatively simple at first glance, it is governed by a complex set of rules. Investors should seek to fully understand their terms before trading the product to avoid falling into a trap for the unwary.

Credit derivatives are financial contracts allowing market participants to take, reduce or transfer credit exposure to a sovereign or commercial entity (reference entities), and generally reference obligations and / or loans (bonds reference) of the underlying reference entity. The universe of credit derivatives includes a variety of derivatives and securitized products, including CDSs, total return swaps and credit-related notes.

Credit derivatives are mainly used by (1) banks and loan portfolio managers to hedge the credit risk of their bond and loan exposures, (2) hedge funds and other asset managers to obtain credit risk. specific credit exposure to benchmark entities or as part of various credit transactions or relative value strategies, (3) insurance companies to enhance asset portfolio returns, and (4) companies to manage credit exposure to third parties.

For more information on International Swaps and Derivatives Association (ISDA) documents, see ISDA Master Agreement: A Practical Guide. For the regulation of swaps by the Commodity Futures Trading Commission and the Securities Exchange Commission, see Swaps and SecurityBased Swaps under Title VII of the Dodd-Frank Act: US Regulation and Swap Dealer and Major Swap Participant External Business Conduct Rules. For cross-border transactions, see Cross-border transactions involving swaps and securities swaps: US regulations.

CDS Basics

A CDS contract is a derivative contract under which one party buys, and the other party sells, credit protection on a set of debt instruments of an underlying corporate or sovereign reference entity (named CDSs). single) or a basket of reference entities (CDS index). Upon the occurrence of certain events relating to the reference entity (Credit Events – see the section called Credit Events below), the CDS contract is triggered and the CDS protection seller usually pays an amount to the reference entity. CDS protection buyer to settle the Contract in cash. This cash settlement amount is usually determined by reference to the value of the benchmark entity’s debt securities secured through an auction process (discussed in more detail in CDS Settlement below).

Credit events are defined in the 2003 and 2014 Credit Derivatives Definitions (Definitions), which are published by the ISDA. References to Definitions and defined terms in this practice note refer to the 2014 Credit Derivatives Definitions. Parties to the CDS contract specify applicable credit events, generally by reference to the ISDA Credit Derivatives Physical Settlement Matrix. listing applicable credit events based on market conventions in the location of the reference entity. In the United States, for example, the credit events applicable to a CDS referring to a legal person are default and bankruptcy.

Decisions as to whether a credit event has occurred and other material issues affecting the CDS contract or its settlement are typically made by an ISDA Credit Derivatives Determination Committee consisting of 15 members. The CD is made up of the 10 largest CDS brokers (based on the notional amount of CDS subscribed) in the particular geographic area and 5 buy-side member companies (which are the same in all geographies). The DC decision-making framework is based on the DC Rules, which are also published by ISDA. The DC generally follows the DC rules, but has the option to deviate from these rules in certain cases if necessary.

When entering into a CDS contract as an end user, a market participant will generally be faced with a swap broker counterparty. Thus, for settlement and execution purposes, payments and / or deliveries will be made between the market participant and its swap counterparty.

The volume of CDS on a specific reference entity is publicly available, but not the identity of the trading counterparties. It is therefore difficult to assess which market players are actively trading the CDS product on a given reference entity and in what size.

Credit events

Credit event determinations are generally made by the distribution center for the region concerned (North America, EMEA and Asia). Any participant in the CDS market can ask the CD to make such a decision. Credit Events must have occurred within 60 calendar days of a request (along with the required information) to be taken into account. This is called a 60-day retrospective period.

The most common credit events applicable to corporate CDS contracts are as follows.

Default of payment

The event of non-payment of credit is usually very clear at first glance. The low payment requirement ($ 1 million / € 1 million) is remarkable because relatively benign defaults can potentially trigger the settlement of the CDS contract. In addition, the Definitions give effect to all applicable grace periods in the underlying debt documentation or, if no contractual grace period applies, the Definitions imply a three working day grace period. The definition is as follows:

“Default of payment” means, after the expiration of any applicable grace period (after the satisfaction of any condition precedent to the beginning of that grace period), the failure by the reference entity to perform, when and where due. , any payment in an aggregate amount not less than the Payment Requirement under one or more Obligations, in accordance with the terms of those Obligations at the time of such breach.

The term “obligation” for the purposes of defining default is very broad. In the United States and Europe, bonds include any form of “borrowed money,” which covers any bond or loan obligation of the reference entity. That said, CDS contracts are generally linked to the age of the obligations to which they refer. Consequently, a CDS contract entered into on the senior bonds of a reference entity cannot be settled by means of subordinated bonds of the same reference entity. “Subordination” refers to contractual subordination, without taking into account guarantee and guarantee agreements and the existence of preferred creditors resulting from the application of the law.

Historically, default was perhaps the most obvious credit event. However, the simplicity of the definition has been put to good use in recent years in the context of defaults generated by market participants with the cooperation of the reference entity (the so-called credit event closely adapted). In order to avoid misuse, tightly tailored credit event terms have been incorporated into corporate CDS contracts and now require that a default is the result of or deterioration in the credit of the credit entity. reference for a credit default event to occur. The relevant rider came into effect on January 27, 2020 for most CDS contracts. He clarified that a payment default will not be considered a credit default event if it does not result directly or indirectly from (or in) the deterioration of the solvency or financial situation of an entity. , as long as the confirmation includes a credit deterioration requirement.

ISDA has also issued interpretive guidance outlining certain factors that the relevant DC should take into account when reviewing a default event. These factors are only indicators of the implication (or not) of a deterioration in creditworthiness and do not claim to be exhaustive or conclusive.

This interpretive guideline introduces an element of subjectivity (and, therefore, uncertainty) in determining the CD for the credit default event. While the added uncertainty is designed to deter market participants from abusing definitions to their economic advantage, it makes the product somewhat less predictable and potentially more susceptible to inaccurate determinations.


The bankruptcy credit event is, in most circumstances, a clear event as it usually involves a bankruptcy or other insolvency filing. However, certain parts of the definition, such as those relating to proceedings to obtain “similar relief under any bankruptcy or insolvency law or any other law affecting the rights of creditors”, are relatively complex and their purpose. resolution may require proper analysis. Bankruptcy is defined as follows:

“Bankruptcy” means that the Reference Entity (a) is dissolved (other than by virtue of a consolidation, merger or merger), (b) becomes insolvent or is unable to pay its debts or fails or admits in writing in any legal, regulatory or administrative proceeding proceeding or disclosing his general inability to pay his debts as they fall due, (c) makes a general assignment, arrangement, plan or composition with or for the benefit of its creditors in general, or such general assignment, arrangement, plan or composition becomes effective, (d) institutes or has instituted proceedings against it to obtain a judgment of insolvency or bankruptcy or any other similar measure under a bankruptcy or insolvency law or other law affecting the rights of creditors, or a petition is made for its liquidation or liquidation and, in the event of such proceeding or petition brought or presented against it, such proceeding or petition (i) results in a judgment of insolvency or bankruptcy or in the registration of one or der for redress or the issuance of an order for its liquidation or liquidation, or (ii) no ‘is not revoked, released, suspended or blocked in each case within thirty calendar days of the institution or presentation thereof, (e) has a resolution for its liquidation or liquidation (other than under a consolidation, merger or merger), (f) seeks or becomes subject to the appointment of an administrator, provisional liquidator, custodian, receiver, trustee, depositary or other similar official for him or for all or substantially all of its assets, (g) a secured creditor takes possession of all or substantially all of its assets or is subject to attachment, enforcement, attachment, a receivership or other legal proceeding imposed, executed or pursued against or virtually all ity of its assets and such secured party retains possession thereof, or such proceeding is not dismissed, released, suspended or restricted, in each case within thirty calendar days thereafter, or (h) causes or is subject to any ev ent in respect of it which, under the applicable laws of any jurisdiction, has an effect analogous to any of the events specified in sections 4.2 (a) to (g).

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Originally posted by Practical Guidance

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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