The default swaps 1 or derivatives credit event 2 or permutations of the unpaid , better known under the name English abbreviation and credit default swaps (CDS) , are contracts of financial protection between buyers and sellers, which were developed from of 1994 at JP Morgan Bank . The protection buyer pays an annual premium of 3 ex ante calculated on the notional amount of the assets to be hedged often referred to as reference or underlying(this amount being also referred to as the CDS notional amount), to the protection seller who promises to offset ex post the losses of the reference asset in the event of a credit event specified in the contract. It is therefore, in terms of financial flows, the equivalent of an insurance contract .
This is an unfunded transaction: without the obligation to set aside funds to secure the transaction, the protection seller receives periodic premiums and increases his assets without any capital investment if no credit event has occurred. place until maturity (the end) of the contract. Otherwise, more or less likely but very expensive event, it is forced to make a contingent payment , so to provide funds ex post . It is therefore an off-balance sheet exposure .
CDS were widely blamed during the financial crisis from 2007 to 2011 and then the debt crisis in the euro area of 2011 4 .
In 1994, JP Morgan Bank granted a US $ 4.8 billion credit line to the US oil company Exxon because of the risks associated with the oil spill caused by the grounding of Exxon Valdez. Such a line of credit could not be held 100% without significantly modifying the balance sheet and increasing the cost of refinancing the bank. A team of bankers led by Blythe Masters worked on a way to transfer some of the risk of this credit line by creating a specific financial product credit she sold in the market through the tradeuse Terri Duhon 5. JP Morgan began standardizing these products, which became known as CDS. Originally, these credit portfolios were named BISTRO for Broad Index Secured Trust Offering. These new financial products were quickly adopted by all banking institutions before being restructured and recognized under the name of CDS. With John Cassano in 1998, JP Morgan bundled these credit default swaps into ” Broad Index Secured Trust Offering” which will be named CDOs. Cassano considers these CDOs(asset backed bonds) as a key event: “It was a turning point when in 1998 JP Morgan contacted us, who worked a lot with them, and asked us to participate. ”
CDS is booming in the 2000s. The consequence is that no one knows where the credit risk is . Presented as dispersed and ventilated, a guarantee of greater security, it is actually concentrated in the off-balance sheet of the largest insurance institutions 6 , 7 .
CDS is considered one of the causes of the September 15, 2008, collapse of American International Group (AIG) 8 , and one of the sources of the uncontrolled spread of credit risk. The CDS market rose from US $ 6,396 billion at the end of 2004 to $ 57,894 billion at the end of 2007, taking on the character of a financial bubble. The bank Lehman Brothers was the first player on this market until its bankruptcy. CDS, off-balance sheet and over-the-counter, allowed to circumvent all prudential rulesand access to CDS was not controlled by the government. Widely seen as a major source of the financial crisis, the most serious since 1929, CDS are in the sights of those who want to strengthen regulations and tighten control of banking activities.
Development of a CDS Contract
The elaboration of a CDS contract requires the approval of the co-contractors on several points.
The reference asset
They must fix the reference asset for which protection is envisaged. These may be debts of sovereign countries , financial institutions or any other business whether or not rated 9 .
The notional amount, maturity, the amount of the premium [ change | change the code ]
The notional value of the asset, the maturity of the transaction, usually 5 years, and the amount of the premium to be paid by the protection buyer are also set .
The definition of credit events
The contracting parties must agree on a precise definition of credit events in order to avoid any ex post dispute . The deficiencies of Russia in 1998 and Argentina in 2002 highlighted the lack of precision in the documentation of CDS contracts, which is exactly a credit event. In this regard, the International Swaps and Derivatives Association (ISDA) has encouraged standardization of the definition of a credit event. A contingent payment by the protection seller is triggered when there is bankruptcy , default of payment, moratorium (payment period) or restructuring (extension of the repayment term).
Since CDSs are bilateral contracts, the counterparties are not obliged to comply with this definition of credit events and often omit the restructuring which does not, strictly speaking, constitute a loss of capital for the buyer. The counterparties must have fixed the compensation to be paid by the protection seller in the event of a credit event.
The contingent payment
The contingent payment means the payment that the protection seller must perform to the buyer if a credit event as planned and described contractually occurs.
The contracting parties must define how the protection seller can make the contingent payment. The seller may wish to make a cash settlement or physical delivery . In the first case, the contingent payment is equal to the difference between the notional amount of the asset and its market price, in the second, the protection seller pays the notional amount of the assets and receives the asset in return. .
For comparison, here is an example: A CDS on an asset of one million euros (notional value) is affected by a credit event, such that the depreciation rate of the asset is estimated at 70%. Under cash compensation , the seller pays 700,000 euros to the counterparty . If the physical payment has been preferred, the protection seller makes a contingent payment of the notional amount of one million euros. The protection buyer delivers the impaired asset (eg bondsvalued at 30% of their nominal value), which encourages the protection seller to wait for an improvement in the situation to sell this asset (bonds) later. This may be less expensive than original cash compensation.
Finally, in the case of a physical settlement, it is appropriate to be fixed on the debt securities delivered to the protection seller, since not all securities have the same priority in the collection structures.
1 basis point of a CDS protecting 10 milliondollars in debt for five years costs 1000 $ per year.
As this is a bilateral contract, the credit risk transfer of single name CDS is direct. It does not therefore go through a SPV ( Special Purpose Vehicle) , that is, an ” ad hoc entity “. CDSs provide pure exposure to credit risk and the set premium level is perceived by market participants as an indication of the credit quality of the assets. Monoline insurers typically sell protection for high quality assets only, with periodic premiums low enough to cover an extremely expensive but highly unlikely potential credit event.
Similarly, CDS premiums for assets considered risky are relatively high. These premiums increase when a borrower’s situation appears to be deteriorating. This was the case for the CDS on Argentine debt in 2001 before its actual default. CDS premiums vary according to changes in the perception of the credit quality of the underlying asset. Through this feature, participants use premium levels to anticipate future credit events.
Calculation of the premium amount
The amount of the premium in basis points of a CDS is calculated according to the assets (if they are bonds, according to the bonds of the same reference or the underlying). The premium may be called the CDS price, CDS value or CDS spread, however, it should not be confused with the credit spread . The remuneration of a bond is expressed from the Liborrate plus a margin. This additional interest is justified by the relatively higher level of risk associated with this asset compared to the investment that is supposed to be risk-free and paid for by the Libor rate ( flat or zero spread ), or even negative.
The premium and the spread
The premium of the CDS whose underlying asset is an obligation must, in principle, be equal to the credit spread of this bond in order to avoid any arbitrage behavior. It would otherwise be possible to make a risk-free investment at a safe profit by holding a bond whose credit spread is greater than the CDS premium of the same asset that is paid to a protection seller.
In the CDS market, there is not always equality between the credit spread and the CDS premium on the same asset. The “base” equal to the difference between the “premium” and the “spread” can be positive or negative.
When the base is positive, the CDS premium being higher than the spreadThis may mean that the demand for credit risk hedging by the banks is too high compared to the protective selling offer. The level of CDS premiums can be explained in this logic by adjusting the price by comparing supply and demand. This is one of the reasons premiums increase when credit quality deteriorates. Banks, seeking to hedge against a particular credit risk appearing to them suspicious, increase their demand for purchase protection that does not coincide with the willingness of investors to satisfy it. The basis may be positive for another reason: the uncertainty in the event of a credit event on the quality of bonds delivered under the physical delivery regime may encourage protection sellers to insist on a higher premium.
The argument put forward to explain the negative basis is the unfunded nature of the CDS. Sellers of protection can indeed be content with a lower remuneration, because their role in a CDS contract does not confronts ex ante at any cost. It is however much less common than the positive base.
Finally, note that the CDS premium is also called “CDS price” , “CDS value” or “CDS spread” , not to be confused with the credit spread (also called bond spread).
There are two families of models for evaluating CDS:
- the structural approach, an extension of the Black-Scholes model (1974);
- the reduced form, which directly simulates the probability of default.
The first model is attractive because it links the credit market to the stock market. However, the model is not flexible enough to match market spreads . The second model is the standard used on the market. The CDS market is very flexible in 2008, and the spread curve is an observable data that allows the model to be calibrated.
A third category, called “hybrid”, inspired by the two previous models has been developed to take advantage of the advantages of each model.
Interest and dangers of CDS
In the traditional analysis scheme of bank activity, it is the banker who analyzes the risks of a credit and assumes it in case of loan. It can share it with other banks in the form of syndication . He manages his risk of insolvency of the debtor by guarantees of various types and if he is mistaken, his capital cash the loss. The organization of credit thus gives pride of place to the capital requirements according to the risk of loan contracts.
The CDS mechanism allows a bank to lend without assuming the full risk of a transaction and without increasing its capital requirements. The insurer, for its part, may depend on different prudential rules that do not require capital requisitions. CDSs were introduced by their promoters as a revolution in banking and risk management. The diffusion of risk and its control by the market had to make the whole more solid. In practice the mechanism has allowed banks to become credit brokers, and to multiply their profits without the need for additional capital and out of sight of the banking regulators.
This “paradigm shift” in banking activity creates a difficulty: the macroeconomic development of a risk of deterioration in the quality of loans and counterparty risk (risk that the insurer can not pay, so that there is no insurance). Considered by its promoters as a way to spread the risk, the CDS actually concentrated 10 . Much of the risk has been grouped around risk-buying organizations, in practice some insurers. Since all operations are bilateral and off-balance sheet, the macroeconomic aspect has remained hidden for a long time to emerge with extreme violence in September 2008 .
The system is largely based on the rating agencies that qualify the risk and in a certain way declare the “credit events”. There have been serious mis-rating of credit rating agencies on derivatives, with abrupt changes that worsened the credit crisis as soon as it began in summer 2007 and rushed into bankruptcy. Lehman Brothers in September 2008. It was ultimately taxpayers’ money that helped finance the counterparty risk. US taxes have paid for example the CDS Societe Generalevis-à-vis Lehman-Brothers. The interconnection of financial systems had become such that the mechanisms to rescue national applicants served to protect international interests 11 .
Another aspect of CDS is that they serve not only insurance but also means of speculation. They are attributed a significant role in speculation on European sovereign debt. This has been clearly seen since the debt crisis hit some of the Euroland countries . To maintain financial market stability, there was reluctance to report a restructuring of the Greek debt because the number and volume of CDS contracts triggered by a decision that would be interpreted by the credit rating agencies [ref. necessary] as a “credit event”.
So far, CDS has not been subject to major international regulatory reform. There is talk of the need to unify the prudential rules and supervisory bodies between the bank and insurance, the change of accounting rules of CDS to get them back in the balance sheet, the creation of compensation platforms to make net counterparty risk, the need for new forms of reporting. The abolition of CDS and the return to the exclusive responsibility of banks for credit risk are sometimes mentioned.
Are CDS a useful financial revolution, an innovation that, like all innovations, must be mastered before it can fully play its beneficial role? Or is it simply a way to circumvent banking rules by creating an unbearable collective risk? This is the focus of the discussions on the financial reforms imposed by the ” Great Recession “.
At the European level, the Directive “on criminal sanctions for insider dealing and market manipulation”, adopted on 20 October 2011 12 , must be transposed into national legislation within two years, but the United Kingdom and the United Kingdom ‘ Ireland have been provided.
The Directive on insider dealing and market manipulation, also adopted on 20 October 2011, concerns in particular the supervision of OTC transactions under the auspices of the European Securities and Markets Authority 13 : “to ensure that any manipulation of the financial instrument markets by over-the-counter derivatives, such as CDS, is clearly prohibited “. However, unless specific national rules, anticipating the transposition of the directive: “its application should take place 24 months after its entry into force”, that is to say no later than 2013 14 . This has already taken place partly in France with Article L.16 , 17 . The legislative framework is thus in place in France, at the end of 2011, to give the authority of the financial markets a power of sanction against possible manipulations of rates which would use the CDS.
In June 2011, the CDS market (notional amounts) accounted for 32 400 billion dollars (49% of world GDP), of which 21 400 billion will reach maturity between 1 and 5 years 18 . Given the magnitude of these figures, the European Union has adopted a regulation on the regulation of short selling and certain aspects of credit risk swap contracts. This regulation will apply from 1 st November 2012. By decision of the European Parliament and the outcome of a negotiation conducted by Pascal Canfin, MEP Europe Ecology Greens, rapporteur for this text, this regulation prohibits in particular bare CDS on the sovereign debt of European states.
Commitments related to CDS (notional amounts outstanding)
- In July 2011, the CDS market in the US, mostly controlled by three US banks ( JP Morgan , Bank of America , Citibank ), covering risks of defects which amounted to 15 227 billion dollars 19 , is almost the GDP of United States . This amount corresponds to the value of the reference assets covered by the CDS sold or purchased by the banks (it includes cross-selling) 19 .
- In December 2010, at the global level, according to the Bank for International Settlements (BIS), the notional amounts of CDS contracts amounted to 29 898 billion (gross) 20 . In March 2009, according to the ECB, the main issuers of non- sovereign securities as reference assets to CDS contracts were the banks: GE Capital , JP Morgan, Goldman Sachs Group, Morgan Stanley , Deutsche Bank and Barclays Group 21 .
- In 2009, each of the UK banks Barclays and RBS made commitments totaling 2,400 billion pounds in CDS (totaling £ 4,800 billion ) 22 . Charles Goodhart felt that the only nationalization of the group Lloyds Banking have passed the English public debt from 45% to 300% of GDP 23 .
- The exposure risk of French banks resulting from their off-balance sheet commitments was higher in July 2010 than French GDP : Crédit agricole for € 929 billion ; BNP Paribas for 571 billion euros ; BPCE for 491 billion eurosand Société Générale for 453 billion euros 24 , 25 (it should be noted that CDS represent only a small part of these commitments).
- In early November 2011, according to Depository Trust & Clearing Corporation , the global amount of CDS contracts written for statements of debt (sovereign) amounts to at least 2 800 billion dollars 26 . This amount is, however, an estimate of the actual amount, since contracts are underwritten directly between contractors (over-the-counter), and are most often known only to them. A study by the IMF believes, however, that contracts registered by DTCC account for 75% of the total volume of contracts issued 27 .
Notes and references
- ↑ Official Journal of the French Republic on 19 May 2009, FranceTerme [ archive ]
- ↑ Securities on the financial markets , S. Praicheux, 2004
- ↑ This premium, expressed in basis points (one basis point = one hundredth of a percent, that is to say one per ten thousand), is equal to the market’s Libor rate plus a margin called ” premium of CDS “.
- ↑ Speculation_on_European_European_Debts # Sp.C3.A9culation_with_CDS_means
- ↑ ( in ) Interview with Terri Duhon CDS  [ archive ] video, The Frontline Interview
- ↑ Didier Dufau The strange disaster. The plunder of prosperity , CEE, 2015, p. 162
- ↑ CDS: worse than the debt, the financial product that could cause the bankruptcy of French banks … [ archive ] , atlantico.fr, 21 September 2011
- ↑ ( in ) The Inside Story of the Collapse of AIG [ archive ] , moneymorning.com, September 23, 2008
- ↑ The lack of rating, and therefore the lack of information, nevertheless affects the liquidity of CDS on this asset.
- ↑ Gillian Tett , Gold fools , The Garden of Books, Paris, 2011
- ↑ AIG scandal: the role of Goldman Sachs and Societe Generale [ archive ] Le Monde, February 2010
- ↑ Directive 2011/0297 (COD) [ archive ] , “Directive of the EUROPEAN PARLIAMENT AND OF THE COUNCIL on criminal sanctions applicable to insider dealing and market manipulation”, October 2011
- ↑ “on insider trading and market manipulation (market abuse), page 7/80” [ archive ]
- ↑ “Press release, Commission, market manipulation” [ archive ]
- ↑ “Banking and Financial Regulation Bill: Senate Report” December 2011 [ archive ]
- ^ “National Assembly report,” bill, amended by the Senate, banking and financial regulation ” [ archive ]
- ↑ “Banking and Financial Bill, October 11, 2010” [ archive ]
- ↑ [PDF] World notional value of CDS [ archive ] Bank for International Settlements (BIS) in June 2011
- ↑ a and b ( en ) OCC Report, pages 7, 12 and 36, Comptroller of the Currency Administrator of National Banks [ archive ] US dept. of the Treasury, July 2011
- ↑ ( in ) The international banking market, CDS table 19 page 131 [ archive ]BIS Quarterly Review, September 2011
- ↑ ( in ) CREDIT DEFAULT SWAPS and counterparty risk , page 27 [ archive ] European Central Bank, August 2009
- ↑ ( en ) Credit Default Swaps explained clearly in five minutes [ archive ]BBC Newsnight – October 2008
- ↑ Cyrille Vanlerberghe, “The specter of nationalization lurking around the British institutions,” Le Figaro , January 22, 2009.
- ↑ Exposure risks of French banks. [ archive ]
- ↑ Another hectic week for the banking sector , Annelot Huijgen, The Journal of Finance , November 13, 2010, page 11.
- ↑ ( en ) “Table 2: Single name reference entity type” line “Sovereign / State bodies [ archive ] DTCC corporation, October 2011
- ↑ “Banque de France, Credit default swaps and financial stability: what risks, 2/15 page” [ archive ]