Credit allocation is at the heart of a bank’s activity. This activity involves assuming a credit risk on loans granted, i.e. the possibility of default by the counterparty. This risk is materialized through the deterioration of the borrower’s credit quality, which may result in a downgrade of the borrower’s rating by a rating agency. One of the solutions for a bank would then be to use risk transfer techniques that would allow banks to benefit from guarantees. Credit Default Swaps ”cds ” were one of the products used by banks to ensure this transfer of credit risk. The incentives to use this product have resulted in a real explosion of the credit risk derivatives market.
However, the Subprime crisis, which these instruments are accused of having aggravated if not provoked, raises questions about the conditions under which this risk was actually transferred and the consequences of this transfer.
The emergence of the CDS market
In 1994, JP Morgan Bank granted a $5 billion line of credit to the American oil company Exxon, following the risks associated with the oil spill caused by the Exxon Valdez operation. However, according to the regulatory framework defined by the Basel agreements in 1988, banks had to have a capital reserve of 8% of the loans granted.
Indeed, the capital cost to J. P. Morgan would therefore have been substantial. To avoid this capital surcharge, the bank has set up a contract with the EBRD whereby the bank would bear this credit risk. In the event of default, the EBRD would compensate JP Morgan and would be remunerated for this protection. JP Morgan would therefore no longer have monopolized capital to secure the loan and could use this amount to finance other activities.
Thanks to the possibility of protecting against risk, the credit derivatives market experienced a major development in the 1990s.
CDS and risk transfer
Among the various credit derivatives, the most widely used CDSs. A CDS connects two counterparties, a buyer and a protection seller. The protection buyer transfers the credit risk associated with a loan to the protection seller without the loan being sold. The protection buyer, who is a risk seller, will be covered in the event of a credit default.
The protection seller is remunerated for this risk taking through the payment of a premium. CDSs also reduce banks’ capital requirements since they provide a guarantee against the risk of default.
The payment of this premium constitutes the fixed leg of the swap, and is expressed as the value of the premium in basis points multiplied by the notional amount of the transaction. If the borrower does not default, the payment of this premium is insured until the end of the contract.
The variable leg of the swap will only be activated if the borrower defaults. The payment of the bonus is then suspended.
Suppose that investor A buys a premium CDS c to B for a certain face value F. This contract covers him against the risk of default from the day of his purchase t=0 until his maturity T, for example 1 year.
A undertakes to pay B an amount proportional to the face value covered ( F x c) over the entire duration of the contract, or until default, if a default occurs. Naturally, the premium rises with the probability of default and falls with the expected recovery rate.
in return, B undertakes to pay it an amount in the event of default, which fully compensates it for its loss.
If the reference asset is missing at t=1, two options are possible for this settlement:
A physical payment, A delivers the security to B and B pays him the full face value F
A cash settlement, B pays A the sum of F x ( 1-R), where R is the recovery rate and A does not transfer the underlying security.
If X fails at t=1
The triggering of a CDS
Four categories of credit events are used by the ISDA (International Swaps and Derivatives Association) definitions to characterize the event triggering a CDS.
First, the bankruptcy of the borrower. The borrower can no longer meet his obligations. Secondly, non-payment, thirdly, acceleration of the debt, when the debt is repaid early. Fourthly, debt restructuring, when one of the characteristics of the debt is changed: reduction in interest, extension of debt maturity, change in currency…
The role of ISDA
To facilitate the management of CDS contracts, banks use a Master Agreement, a contract offered by ISDA. This contract sets out the terms and conditions of the sale of protection and allows for the possibility of adding more. This prevents a number of disputes over CDS settlement terms and conditions, e.g. Russia 98 after restructuring its debt.
Since March 2009, the market has evolved towards a standardisation of CDS trading and settlement procedures, with the ultimate objective of facilitating the use of clearing houses. Today, we have succeeded in solving the problem of operational risk related to the time required to validate transactions.
The implementation of an electronic Deriv/SERV platform has made it possible to automate and confirm 98% of transactions electronically, compared with 50% for all OTC derivatives. But the ISDA protocol requires the consent of the counterparty before the contract is transferred to this new entity through an electronic confirmation process.
However, the most emblematic development is the management of the settlement of credit events. Argentina’s default in 2001 was the first to raise the question of CDS settlement when the amount of CDS on a given reference entity is higher than that of the underlying debt.
Indeed, as with any derivative product, there is no limit to the amount of CDS that can be signed on a reference entity. Therefore, in the context of a physical settlement, protection buyers, if they did not initially hold the debt, will have to obtain it on the market in order to be able to deliver it to protection buyers.
For example, the Delphi bankruptcy in 2005 showed that there was 5.6 times more notional in CDS than debt (USD 28 billion in CDS versus USD 5 billion in bonds and borrowings).
CDS as a vehicle for systemic risk
The increase in activity on the CDS market is largely due to speculative activity, the objective and above all to make profits through trading strategies. Changes in CDS premiums are likely to have an impact on the prices of other financial assets.
The transfer of information between the CDS market and its underlying market can have consequences not only for corporate financing conditions but also for the economy as a whole. In addition, CDS are considered as reference tools by market participants to measure the soundness of companies.
CDSs and incentives for creditors of companies in financial distress
Before the CDS market, creditors were often tempted to let a company in financial distress survive for a period of time, even if it had to abandon part of their receivables, in order to pass the fateful deadlines. These delays could in some cases save the company from bankruptcy.
Creditors thus sought to avoid bankruptcy proceedings as much as possible, as this involves either a long and uncertain recovery of debts or the resale of the debt on a secondary market where a significant discount must be accepted.
The existence of CDSs has reversed creditor incentives. If the value of their debt is fully covered by a CDS, creditors now have an interest in bankruptcy as quickly as possible. Bankruptcy automatically triggers the settlement of CDSs within a period of less than one month.
Creditors are then assured of recovering the full face value of their claim. Incentives to negotiate, to grant new loans or delays, disappear completely in the face of the prospect of this full and rapid payment. CDS holders who do not own the underlying debt are even more eager to see a default trigger.
Counterparty risk management and its limits.
This risk corresponds to the default of one of the two parties to the contract. In the event of a default by the protection buyer, the protection seller will no longer receive the premium related to the contract. In the event of a default by the protection seller, the buyer will lose his coverage and will have to replace the contract.
It will therefore incur a cost, the replacement cost, if the level of the CDS premium has increased in the meantime. It may also include the inability of the protection seller to settle the variable leg of the contract in the event of default by the reference entity. The multiplication of CDS contracts, linked to the continuity of positions, contributes to a significant increase in counterparty risk on the market.
To protect themselves against counterparty risk, market participants combine their positions in the form of an initial margin at the signing of the contract and regular margin calls to cover the net residual exposure of one party to the other and thus mitigate the loss incurred in the event of default.
Collateral will allow the non-defaulting counterparty to replace its position 21, it also constitutes a provision for a possible settlement. When an entity starts to have problems, several mechanisms are put in place to trigger additional margin calls. The signal can be given by increasing the CDS premium or lowering the bond price; in some cases, mainly in the United States, it can be the downgrading of the rating of the reference entity or the seller.
However, several factors limit protection against counterparty risk.
First, although almost all major banks operating in the market are collateralized and the amount of collateral is reviewed on a daily basis, this is not the case for all transactions. According to ISDA, two-thirds of credit derivative exposures are covered by collateral.
Second, margin calls are pro-cyclical. A deterioration in the situation of the protection seller, such as a downgrade by rating agencies, will result in an increase in margin calls. This request for additional collateral is likely to trigger a liquidity crisis and weaken the distressed entity or even precipitate its default.
A transfer of credit risk limited by high market concentration
The risks that were supposed to leave the financial system finally remained concentrated there. Banks accounted for 58% of CDS buyers and 43% of sellers in 2006; hedge funds accounted for 29% of buyers and 31% of sellers (IMF, 2008). At the end of 2008, at the global level, the ten main participants accounted for more than 90% of the gross notional amounts of CDS.
This concentration is strongest in the United States, where the five largest commercial banks account for 97% of market activity, of which 30% is carried out by Bank J.P. Morgan. The failure of financial entities active in the CDS market such as Lehman Brothers, the near bankruptcy of AIG and the withdrawal of many hedge funds have contributed to further concentration of players.
In addition, this has led to an increase in counterparty risk. Moreover, while the risks remain in the financial sphere, the protection sold largely concerns the financial sector itself. The credit derivatives market did not therefore transfer the risks it was supposed to insure.
Far from having redistributed credit risk, CDSs have contributed to the intensification of systemic risk through the concentration of risks on a small number of highly connected players, few in number and at the same time buyers, sellers and underlyers.
In particular, the default of a dealer is likely to cause a domino effect and spread the risk of default. This has led to the emergence of a new type of systemic risk, the too interconnected to fail, which has replaced the too big to fail (Brunnermeier, 2009).