Credit Default Swaps (“CDS”) are the base contract in the credit derivatives market. Very simply, this form of swap enables the credit risk of financial assets to be transferred from one party to another without actually transferring ownership of the assets themselves.

Use of Credit Default Swaps

The unique characteristics of CDS offer benefits to a range of participants in the credit markets:

Hedging Credit

• CDS allow capital or credit exposure constrained businesses to free up capacity to facilitate doing more business.
• CDS can be used as a very efficient short positioning vehicle - it is often easier to buy credit protection for a desired tenor than to short actual cash bonds.
• Assigning bank loans often requires borrower consent and/or notification - CDS can be used to confidentially transfer the credit risk of such loans without disturbing important borrower client relationships.
• CDS may avoid the triggering of any tax or accounting implications that can arise upon an actual sale of assets.

Investing in Credit

• CDS may be used to take a view both on the deterioration or improvement in the credit quality of a reference credit.
• CDS may offer investors higher returns for assuming very similar credit risk positions, e.g. as an alternative to a direct bond investment - as such, CDS can present new opportunities to relative-value investors.
• CDS may offer protection sellers access to hard-to-find credit risk, e.g. access to credits for which there is a limited supply of bonds or where the borrower deals primarily with a small syndicate of bank lenders and have no public bonds outstanding.
• CDS can offer investors an opportunity to invest in credits that trade in foreign markets without bearing unwanted currency risk.
• Investors can use CDS to tailor credit exposures to match their precise maturity requirements, as well as desired seniority in a company's capital structure.
• CDS require no initial cash outlay, and are therefore an efficient tool for making leveraged credit investments.

Basic Credit Default Swap Structure

CDS are similar in design to credit insurance contracts. In a CDS, the default protection buyer makes fixed periodic premium payments to the protection seller in exchange for being made whole on a set amount of notional principal should the specified reference entity experience a “credit event” (e.g., failure to pay, bankruptcy, restructuring). The typically term of a contract ranges from 2 to 5 years, and the typical reference entity is rated investment grade.

Credit Events

Payments under a CDS are triggered by credit events that must be clearly defined. ISDA has produced standardized documentation to address this, wherein the counterparties to a CDS trade decide which credit events they wish to apply. The credit events included most often are:

• Bankruptcy
• Failure to Pay
• Restructuring

Some CDS specify a reference asset (e.g., often a senior unsecured bond issued by the reference credit). The main purpose of the reference asset is to specify the capital structure seniority of the debt that may be delivered following a credit event in physically settled trades. In cash settled transaction, the reference asset is valued post-default to determine the amount of settlement payment required. The maturity of the CDS need not match the maturity of the reference asset. Normally a reference asset is selected with a slightly longer maturity than the CDS.

Cash or Physical Settlement Following A Credit Event

CDS may either be cash settled or physically settled should a credit event occur. In a cash settled transaction, dealers are polled for a set period of time (i.e., usually up to 3 months) following a credit event to determine where the reference asset is trading, as a percentage of par. If, for example, the reference asset is, on average during that period, trading at 55 percent of par, the protection seller would be required to pay the protection buyer 45 percent of the notional amount, representing the difference between where the asset is trading and par. On the other hand, in a physically settled transaction, the protection buyer is required to deliver a debt obligation (e.g., typically a bond or loan) equal to the notional amount of the CDS contract to the protection seller in exchange for payment at par. The protection seller then has recourse to the reference entity and has the opportunity to participate in the workout process as an owner of a defaulted debt obligation. The CDS market considers physical settlement to be the market norm, primarily to enable protection sellers to have some control over their timing of recovery on a defaulted credit.

Straight Forward Documentation

The documentation for CDS, which includes a standardized letter confirmation referencing an ISDA Master Agreement, is relatively easy to use, facilitating quick turnaround time and contributing to improved liquidity in the marketplace. ISDA has published standardized Credit Derivative Definitions, which are used in CDS contracts. These definitions, along with sample confirmations, may be accessed at ISDA's website.

In Summary

Using CDS, banks can now buy credit default protection and reduce excess exposures that they might have in their loan portfolios, without disturbing valuable customer relationships. CDS also allow active credit traders to short credits that they believe may underperform without the delivery complications of shorting actual bonds. And using CDS, corporate bond investors can easily and efficiently diversify and optimize the credit risk of their portfolios across an expanded set of borrowers, including those who do not issue bonds. Because Credit Default Swaps are such a powerful risk transference tool, their use has grown rapidly and globally, and should continue to develop more credit market efficiencies as even more participants become active.