Financial literacy | Securities in plain language. Credit derivatives: protection against default

What you need to know about a credit derivative – an instrument that belongs to the second wave of derivatives and is intended for credit risk insurance

The National Securities and Stock Market Commission (NSSMC), together with LIGA.net, has prepared a series of publications to explain the essence and specifics of financial instruments and mechanisms of their use in a simple and accessible manner.

In our previous publications, we have discussed the economic essence, characteristics, and specifics of fundamental derivatives, such as forwards, options, and swaps. Today we will move on to the second wave of derivatives – credit derivatives.

Economic essence

The main purpose of credit derivatives is to transfer credit risk from a party willing to minimize risks to a party willing to accept it for a fee.

The most important instrument of the credit derivatives market, which is an integral part of all other credit derivatives, is a credit default swap (CDS). Simply put, a CDS implies that one party buys credit protection from the other against the possible occurrence of a credit event (a default).

A credit event is usually understood as a debt restructuring, debt default, refusal to pay a debt, bankruptcy, etc. All of these examples indicate the inability of a third party to fulfill its obligations, but the specifics of a credit event may vary and are determined by the parties when entering into a CDS.

The party that transfers credit risk through a CDS is called the buyer of the protection, and the party that accepts the credit risk is called the seller of the protection. To pay for the protection, the buyer of the protection makes one-time or regular payments to the seller of the protection. These payments are called premium leverage and may continue until the end of the CDS term or until the credit event occurs.

The size of the premium leverage for a CDS depends on the third party’s assessment of the reliability of the CDS. This assessment should be based either on the protection seller’s own expertise (if it has the necessary competencies) or on a rating assigned by a relevant rating agency.

If the credit event occurs before the expiration of the CDS, the seller of the protection is obliged to pay the buyer of the protection an amount of money called the leverage. This payment depends on the agreements of the parties and is usually reduced to two options:

• «physical delivery» – repurchase of an asset (loan agreement, bond, bill of exchange or other agreement) related to a third party from the buyer of the protection at par value or at the price agreed upon at the time of entering into the CDS;
• «cash settlement» – compensation to the buyer of the protection for losses in the amount of the difference between the nominal and current value of the third party’s obligation.

Formats of credit derivatives

The standard and most common format of credit derivatives is the swap format discussed above. This format is also called unfunded, as in this case only the premium leverage (hedging fee) is paid.

Another format of credit derivatives is the credit note, a security with an embedded credit default swap. In essence, a credit note is a symbiosis of a credit default swap and a bond: note buyers receive fixed or floating coupon payments until a credit event occurs. If the credit event does not occur, the issuer will repay the face value of the credit note at the end of its term. However, in the event of a credit event, the issuer redeems the loan notes ahead of schedule at the redemption rate specified in the prospectus.

An interesting feature of credit notes is that the issuer can act as both a seller of credit protection (forward model) and a buyer (reverse model).

Evolution of credit derivatives

As financial markets have evolved, credit derivatives have been modified and supplemented to offer investors and hedgers a wider range of applications. Today, there are four stages in the development of credit derivatives.

At the first stage, credit derivatives, namely CDSs, were used to simply insure a party (hedger) that had an economic relationship with a third party (also called a «related party») and depended on its solvency, but had no influence on such a party. The other party, an investor who could professionally assess the credit risk of the third party, sold the protection against default for a fee. For example, Party A owns Party B’s bonds and is concerned about the issuer’s default risk, so Party A agrees to make periodic payments to Party C, which agrees to compensate Party A for its losses in the event of Party B’s default.

At the second stage, credit notes appeared, namely their most famous variation – credit-linked notes – securities with an embedded credit default swap, which provide for a direct link between raising funds (in the case of securities placement) and their use – granting a loan or purchasing debt instruments issued by a related party.

For example, a bank, financial company or target company places loan notes among investors and uses the proceeds to make a loan to a related company. In such circumstances, a link is created between the loan note and the loan to the related company. In this case, the issuer acts as the buyer of the protection, and the note buyers act as the sellers of the protection (reverse model). In the next step, the issuer extends credit to the related party, and a link is created that allows for the transfer of credit risk. As a rule, the loan is secured by credit notes (also called covered notes).

During the life of the loan notes, the issuer pays the coupon rate and, if no credit event occurs, redeems the notes at maturity. If a credit event occurs during the life of the loan notes, the issuer redeems the loan notes at a ratio of less than «1» or gives the noteholders the resulting asset at par value.

The third stage in the development of credit derivatives resulted in the emergence of unrelated credit notes, which no longer involve the issuance/creation of a new asset (including a loan), but provide for a connection between the hedger and a related party, and the issuer of the credit notes acts as a seller of protection (direct model).

Thus, in order to protect against a possible default of a related party, the hedger approaches the protection seller with a desire to buy loan notes from it. But in this case, the issuer of the notes may no longer be only a bank, financial company or target company. This is how financial speculators entered the market, raising funds from hedgers (buyers of protection) and using these funds subject to the restrictions specified in the prospectus (Resolution). For example, by transferring assets acquired through the placement of credit notes as collateral for such notes.

During the life of the loan notes, the issuer pays the coupon rate and, if no credit event occurs, redeems the notes at maturity. If a credit event occurs during the life of the loan notes, the issuer redeems the loan notes at a ratio greater than «1».

At this stage of credit derivatives development, the main question is: «Can the issuer of the loan notes adequately assess the credit risk of the related party?» If the issuer of the notes was not a credit institution, it was usually a rating agency’s assessment that was relied upon. It is worth noting that both issuers of credit notes and related parties (who generated credit risk) could be subject to rating.

At the fourth stage of credit derivatives development, financial market participants abandoned the direct link between the hedger and the entity with which they are associated with credit risk. For example, Company A has savings in a foreign bank, but fears that the government of that country will default in the coming years, which will negatively affect the banking system in general and the servicing bank in particular (the assumption is that the level of credit risk of the country and the bank changes in a coordinated manner). Therefore, Company A finds a seller of foreign government default protection for the amount of its savings in a foreign bank.

Of course, as credit derivatives have evolved, other configurations of models for using these derivatives have emerged.

For example, credit derivatives are divided into single-name and portfolio credit derivatives based on the number of liabilities being hedged.

Single-name credit derivatives involve only one economic entity as a related party. This type is the simplest in terms of its structure and mechanism.

Portfolio loan notes involve several economic entities as related parties. If a specified credit event occurs, the mechanism of payment of protection by the seller is complicated by the need to make adjustments in proportion to the share of the economic entities affected by the credit event in the portfolio of “related companies”. At the same time, such payment can be made either at the end of the derivative term (a linear derivative provides that each subsequent credit event reduces the amount of payments) or immediately upon the first credit event in the portfolio (a non-linear derivative).

Comparison of credit default swaps and credit notes

As already mentioned, a credit default swap is the basis of any credit derivative, while a credit note is a more complex form of it.

A credit default swap in the form of a derivative contract is easier to use and does not require significant financial resources, as there is no need to pay the nominal value, as in the case of issuing credit notes.

At present, the use of credit default swaps gives rise to legal uncertainty, as the Law of Ukraine on Capital Markets and Organized Commodity Markets (hereinafter referred to as Law No. 3480) legitimizes the use of CDS, while the current version of the Tax Code does not (CDS is not included in the list of derivatives set out in the Tax Code of Ukraine, which makes it unattractive for use).

Credit notes are a more protected instrument, as they are equity securities, which means that the NSSMC is involved at the very first stage of the derivative’s existence. As a rule, credit notes are used when it is planned to raise funds and/or involve a significant number of persons in this process (as buyers or sellers of protection).

To date, only one case of credit note issuance has been recorded in Ukraine.

Conclusions.

Credit derivatives are an instrument designed to insure against credit risk (default by a counterparty), although the buyer of the protection may not bear the credit risk or bear it indirectly.

It should be noted that one of the features of these derivatives is an individual approach to each transaction, which makes it possible to distinguish certain types within the above classification depending on the derivative components and financial parameters of the transaction.

Credit derivatives are a very efficient and effective mechanism for hedging and speculation in financial markets, which has long been successfully used in international capital markets. However, they require skilled use and professional regulation. A person assuming credit risk must have the knowledge and ability to properly assess this risk or rely on professional, unbiased judgment.

In the context of this publication, the adoption of the draft law on rating and harmonization of the provisions of the Tax Code of Ukraine with the provisions of Law No. 3480 is particularly important.

In the next publications we will start to talk about the mechanism that marked the third wave of derivatives – securitization.

The text was prepared by the NSSMC specially for LIGA.net