Credit Default Swap and Credit Event

Image result for credit default swap explainedIntroduction

Warren Buffett, the CEO of Berkshire Hathaway, described Credit Derivatives six years before financial crisis in the US as ‘financial weapons of mass destruction’, carrying dangers that, are potentially dangerous.[1] However, Berkshire Hathaway (Buffet’s Company) gained $633 Million from derivatives transactions in 2015, it was increasing significantly from $329 Million in 2014.  Recently, he has issued again a fresh warning that “the complex derivatives lurking on banks’ balance sheets are a potential time bomb that could explode in times of stress”.[2] It can be assumed that credit derivatives can be dangerous on the one hand, but also it can be so beneficial on the other hand.

Credit derivatives are financial instruments that trades over the counter (OTC), and its profits are related with the risk of the default of an underlying asset. Within the credit derivative market, the credit default swap (CDS) is the most widespread instrument.[3] A CDS is also categorised as the derivatives with contingent payment which means payment is triggered when a credit events occurred, those can be bankruptcy or default on reference entity or a ratings downgrade of a reference entity below a threshold level (default requirement) agreed in the contract.[4]

Credit Default Swap

  1. Concept

Basically Credit Default Swap (CDS) works in a transaction when the seller of protection agrees to pay the buyer of protection with an amount in relation with the reference obligation of a reference entity if during such agreed period credit event occurs.[5] The simple description of the mechanism of the Credit Event in CDS transaction can be seen as follows.

Image result for credit default swap

Diagram 1. Credit Default Swap

Many people would argue that CDS transactions resembles an insurance contract, because it protects the protection buyer against pre-defined credit events, in particular the risk of default, affecting the reference entity, during the term of the contract, in return for a periodic fee paid to the protection seller.[6] However, an important difference is that neither party of a CDS contract needs to own the referenced underlying entity, have an insurable interest, or suffer any loss. These are called “naked swaps”.[7]

In terms of Credit Default Swap, the buyer of protection typically has certain commercial objectives such as to create a right to receive a cash flow in the event that an entity to which the investor has a direct exposure fails to make a payment obligation and to speculate on the performance of a particular entity, or category of entities to perform on their debt or other obligation.[8]

  1. Credit event

The system works when there is a credit event. The seller of protection (the party assuming the credit risk) either pays the buyer of protection an amount equal to the loss in value of the reference obligation attributable to credit event, which is called cash settlement, or more usually buys reference obligation or an equivalent obligation at its nominal value which is called physical settlement.[9]

As mentioned above, it is essential that the credit event is properly phrasing and restructuring in the operation of credit derivative transaction. Therefore, ISDA has produced ISDA 2014 Credit Derivatives Definition. There are some possible credit events of CDS transactions based on ISDA 2014 Credit Derivatives Definition. [10]

2.1. Bankruptcy

ISDA 2014 Credit Derivatives Definition has completely defined the term of bankruptcy. It includes not just hard insolvency events determined through a court process, but also various events that may occur prior to an insolvency. Broadly speaking a Bankruptcy event occurs if a Reference Entity:

  • is dissolved (other than pursuant to a consolidation, amalgamation or merger);
  • becomes insolvent or is unable to pay its debts;
  • makes a general assignment, arrangement or composition with or for its creditors;
  • wound up or liquidated (other than pursuant to a consolidation, amalgamation or merger);
  • becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar for all or substantially of its assets;
  • has a secured party take possession of all or substantially all its assets.[11]

2.2. Obligation Acceleration

Obligation acceleration means one or more obligations in an aggregate amount of not less than the default requirement (exceed a minimum threshold) have become due and payable before they would have been due and payable on the basis of a default, other than a failure to make any required payment, in respect of the reference entity under one or more obligations.[12]

2.3. Obligation Default

Obligation default covers the situation, other than a failure to pay, where the relevant obligation becomes capable of being declared due and payable as a result of a default by the reference entity before the time when such obligation would otherwise have been capable of being so declared. The default requirement builds in a minimum threshold which the relevant sum being defaulted must exceed before the credit event occurs.[13]

2.4. Failure to pay

One of the causes of credit event is failure to pay. This event is exactly as it says: if a reference entity fails to make a payment when and where due on one or more of its obligations in an amount at least as large as the payment requirement, then once any applicable grace period has passed, a failure to pay event occurs.[14]

2.5. Restructuring

Restructuring means that, any one or more of the following events occurs in a form that binds all holders of such obligations, such as: [15]

  • A reduction, postponement or deferral of Obligation principal or contractually agreed interest payments;
  • A reduction in the amount of principal or premium payable at redemption;
  • A postponement for the payment;
  • A change in priority ranking causing subordination to another Obligation.

Restructuring differs than bankruptcy, failure to pay, moratorium, obligation acceleration and obligation default which automatically trigger credit event. It is not automatically trigger of the CDS contract once a Restructuring occurs. It is up to the protection buyer or protection seller to decide whether or not to trigger (with only one required to trigger for the contract to be triggered).[16]

2.6. Repudiation/Moratorium

Repudiation/moratorium is an event when an authorized officer of the reference entity rejects or challenges the validity of, one or more obligations or declares a moratorium with respect to one or more obligations in an aggregate amount of not less than the default requirement. [17]

2.7. Governmental Intervention

Governmental intervention is caused when a government’s action or announcement results in binding changes to certain obligations of a reference entity including a reduction or postponement of principal or interest or further subordination of the obligation, an expropriation, transfer or other event which mandatorily changes the beneficial holder of the obligation, or a mandatory cancellation, conversion or exchange of the reference entity’s obligations.[18]

Bibliography

[1] W. Buffet, Berkshire Hathaway Annual Report, (2002)

[2] (http://www.telegraph.co.uk/business/2016/05/01/warren-buffett-issues-a-fresh-warning-about-derivatives-timebomb/) last visited (8-11-2016)

[3] (http://www.investopedia.com/terms/c/creditdefaultswap.asp) last visited (8-11-2016)

[4] J. Chan-Lau, Anticipating Credit Events Using CDS with an Application to Sovereign Debt Crises, IMF Woking Paper, at 3 (2003)

[5] P. Wood, Law and Practice of International Finance, at 432 (2007)

[6] J. Kiff, et all, Credit Derivatives: Systemic Risks and Policy Options, IMF Working Paper, at 4 (2009)

[7] M. Swantek, A Brave New World: Credit Default Swaps and Voluntary Debt Exchanges, John Marshall Law Review, at 1232 (2012).

[8] A. Hudson, The Law of Financial Derivatives, 3rd edition, at 77 (2002)

[9] P. Wood, Law and Practice of International Finance, at 434 (2007)

[10] The 2014 ISDA Credit Derivatives Definitions are an updated and revised version of the 2003 ISDA Credit Derivatives Definitions. This document contains the basic terms used in the documentation of most credit derivatives transactions. The ISDA 2014 Credit Derivatives Definitions Protocol was open from August 21 to September 17, 2014.

[11] ISDA Credit Derivatives Definitions 2014, Section 4.2.

[12] ISDA Credit Derivatives Definitions 2014, Section 4.3.

[13] ISDA Credit Derivatives Definitions 2014, Section 4.4.

[14] ISDA Credit Derivatives Definitions 2014, Section 4.5.

[15] ISDA Credit Derivatives Definitions 2014, Section 4.7.

[16] H. Haworth, A guide to Credit Events and auctions, Credit Suisse Paper, at 9 (2012)

[17] ISDA Credit Derivatives Definitions 2014, Section 4.6.

[18] ISDA Credit Derivatives Definitions 2014, Section 4.8.

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