ABS series (5): as ABS default risk climbs, how CDS manages risk

How CDS works, and how it has developed

CDS, or credit default swap, is the commonest credit derivative in foreign bond markets. It is in substance a contract under which, over a set period, buyer and seller exchange risk in relation to a specified credit event. The buyer of credit protection pays a fee at intervals during the term, or before a credit event occurs, to the seller of credit protection

in respect of a reference entity's

credit event, in exchange for payment once a credit event occurs.

In a credit default swap the buyer pays the seller a fee at intervals, known as the CDS spread, and once a credit event occurs the buyer is entitled to deliver the bond to the seller, thereby effectively avoiding credit risk.

Because CDS products are relatively simple to define and easy to standardise, and simple to trade, they have developed rapidly in the advanced financial markets since the 1990s and have spread gradually around the world.

A CDS is in effect a kind of "insurance" for the claim the creditor holds. The buyer pays the seller a fee at intervals, and the seller undertakes, during the term, to compensate the buyer for the corresponding loss if a credit event occurs in the specified asset.

In practice, however, a CDS differs greatly from insurance:

in regulatory requirements, CDS is at present less supervised than the insurance industry;

in the reference asset, a CDS may float free of the underlying asset, that is, the buyer of credit protection need not hold the reference bond in order to trade the CDS;

in the weight given to price, take motor insurance: once an accident has occurred, the insured who is paid does not care about the value of the wrecked car, whereas after a CDS credit event the price of the reference bond is still a matter of concern to the CDS buyer.

A CDS transaction usually takes place between two participants. Buying CDS is called buying protection, or long protection, and the buyer is called the "buyer of credit protection"; selling CDS is called selling protection, or short protection, and the seller is called the "seller of credit protection". The buyer is typically a bank and the seller typically an investment bank or

lead underwriter.

Only a default of the reference entity triggers the swap. Default and credit event are slightly different notions: a credit event is an event specified in the legal documentation of the financial transaction concerned. Under the standard credit default swap

documentation of the International Swaps and Derivatives Association (ISDA) of 2003, credit events include bankruptcy, repudiation and suspension or deferral of payment, restructuring, failure to pay and acceleration of debt.

The typical types of CDS

There are at present three main types: the single-name credit default swap, the basket credit default swap and the credit default swap index.

The single-name CDS is the earliest form of credit derivative and a relatively common one. A single name means that there is only one reference asset: the buyer pays the seller an agreed premium or coupon at intervals until the contract matures, and the seller undertakes to meet the buyer's claim if a default event occurs in the reference asset; once it occurs the contract

terminates.

The basket credit default swap. The seller of credit protection may sell protection on several assets. In a first-to-default basket swap the seller bears the default risk of the basket during the term by compensating the loss on the first asset in the basket to default. That is, during the term the seller earns premium income from selling protection on a defined basket of assets while bearing

the default risk of that basket

of assets until one of them defaults, when the contract ends and the protection seller pays the loss on the defaulted asset; if no asset defaults during the term, the seller of credit protection has simply earned a premium.

The credit default swap index reflects the movement over time of the sum of the risk-weighted CDS values of the individual reference assets in a portfolio formed from the credit risk of several single entities. Compared with a basket credit default swap it is more standardised, contains more reference assets and has wider coverage. At present the main CDS indices include the European

index and the North American index.

CDS in China

At the end of 2016 the Chinese version of the CDS finally arrived. On 23 September 2016 the National Association of Financial Market Institutional Investors published the Rules for the Pilot Business of Credit Risk Mitigation Tools in the Interbank Market (the business rules) and the Guidelines for Credit Default Swap Business (the guidelines).

According to a notice published by the association on 1 November, its professional committee on financial derivatives had on 31 October approved the registration of 14 institutions as core dealers in credit risk mitigation (CRM) tools. At the same time, 10 institutions, including the five large banks — Industrial and Commercial, Agricultural, Bank of China, Construction and Communications — together with Minsheng Bank, Industrial Bank, Zheshang Bank, Bank of Shanghai and China Bond Credit Enhancement,

carried out 15 credit

default swap transactions, with a total notional principal of 300 million yuan and terms ranging from one to two years.

Under the business rules, participants in CDS in China now include "financial institutions, qualified credit enhancement institutions, unincorporated products and other non-financial institutions", and "the requirements for overseas institutions to trade risk mitigation tools will be published separately by the competent departments in accordance with the relevant provisions".

Under Articles 10 and 11 of the business rules, the debts for which a CDS may provide credit risk protection to a reference entity are bonds, loans and other similar debts, and CDS products fall into contract products and certificate products. Under the guidelines, the types of debt of a non-financial corporate reference entity are for the present limited to the non-financial

corporate debt financing instruments

registered and issued with the association, and the association's professional committee on financial derivatives will gradually widen the range of debt types as the market develops.

The guidelines make clear that the credit events specified for a CDS transaction must include at least payment default and bankruptcy and may, according to the actual credit position of the reference entity, also include acceleration of debt, potential acceleration of debt, restructuring and other credit events.

An institution wishing to take part in CDS trading must, under the business rules, join the association as a member and file its internal operating procedure and risk management system for trading in credit risk mitigation tools with the association; those documents must cover at least business authorisation and division of labor, execution and management of trades, risk forecasting and monitoring,

and the handling of credit events once

triggered, risk reporting and internal audit.

CDS and ABS are both new products in China's bond market. As for ABS, it may be boldly supposed that CDS products referencing ABS could be developed, so as to disperse and transfer risk one step further, using the strong liquidity, low transaction cost and high efficiency of CDS to connect the market, raise scale, gather participants and match buyers with sellers.

Moreover, CDS is recognised

as a key indicator reflecting credit risk across the whole market: its movement can also reflect the operating condition of small and medium-sized enterprises and the direction of an industry, which helps guard against financial risk and keep watch for systemic risk. Looking ahead, once CDS products on ABS are launched, when the rating of an investment is downgraded managers and investors will have more choices, and need neither sell in helpless haste

nor simply wait for the worst.