Imagine being a company and in dire need of money but with a low credit score. The banks are hesitant to lend a borrower money. This is where a credit derivative (CD) comes into play.
To understand what a credit derivative is, let us first understand what a derivative is.
Unlike bonds and stocks, the value of derivatives stems not from their intrinsic value but from another underlying asset. It is a type of security whose value is determined by any other asset.
For credit derivatives, that underlying asset is the “credit” or the loan taken by an institution from a bank. Simply, it is a security that is issued by a bank while offering a loan to a company with a bad credit reputation. That CD is signed by another company that guarantees that in case of a default by the first company, they will pay the loan in full.
The mechanism of credit derivatives allows banks to protect themselves from credit risk globally. In India, the use of CDs has not yet been formalized.
Understanding Credit Derivatives
CDs are often referred to as ‘off-balance sheet financial instruments, whereby a party (beneficiary) can transfer the credit risk of the entity’s assets without actually selling them. By doing so, it ‘unbundles’ credit risk as well as trades it separately.
A credit derivative is an over-the-counter (OTC) financial contract. This means that they do not have standardized terms and are not listed on the bourses.
An example of clarity
Suppose a company, XYZ Corp, wants to borrow $100 million from ABC Bank. But XYZ Corp does not have a very reliable credit repayment history. Yet, it is in dire need of money. What does ABC Bank do?
ABC Bank asks XYZ Corp to buy a credit derivative (CD). The bank will transfer that CD to a third party, 123 Ltd, that agrees to pay $100 million and the interest due if XYZ Corp defaults.
What does the bank get? What is the security that their loan will be repaid?
What does XYZ Corp get? The money it wants
What does 123 Ltd get? Annual fees from XYZ Corp in return for the guarantee
What if XYZ Corp defaults? Then 123 Ltd will have to pay the loan amount with the interest due.
By using credit derivatives, credit risk can be transferred from one party to another without the underlying portfolio being transferred.
The value of CDs depends more on the reliability of the third party than the rating of the actual borrower.
US commercial banks extensively use credit derivatives. In order to mitigate credit risk, banks use them to gain exposure to the credit market and expand their portfolio of credit. Aside from that, insurance companies also use them to improve the returns on their asset portfolios.
In addition to credit derivatives, credit-linked notes (CLNs) can also serve the same purpose, but they are on-balance sheet instruments. As a result, the lender is protected from the loss associated with the risk of the borrower defaulting.
Different Types of Credit Derivatives
There are two main types of credit derivatives — Unfunded and Funded.
1. Unfunded credit derivatives
In these derivatives, no advance payment is made to cover future defaults. Here, each party is responsible for making the required payments only afterward. Since there is no backing, they are termed ‘unfunded’.
Once the settlement is met, the seller of these securities or the borrower of the loan makes the payment. Credit risk lies with the third party on whether the borrower will be able to pay any money/physical settlement amount. The most common and popular unfunded credit derivative is the Credit Default Swap (CDS).
Some Popular Types of Unfunded Credit Derivatives:
Credit default Swap (CDS):
As part of a credit default swap, the borrower of the credit negotiates an upfront or continuous fee in order to compensate the third party in the event of a specified event, such as a default or failure to make a payment.
Both parties benefit from CDS by removing risky entities from their balance sheets without having to sell them. The third-party gains higher returns by entering markets they may not otherwise be able to access.
Credit default swap option:
A credit default swap option on a specific reference credit with a specific maturity is referred to as a credit default swaption or credit default option. CDS options are simply options on CDSs. During a specified period in the future, the holder can sell or buy protection but is not obligated to do so.
Asset-backed CDS (ABCDS):
These swaps are backed by assets. In case of a default, the asset can be sold and money recovered.
Total return swap
Here the assets that back the guarantee are loans and bonds. In case of a default, the payer of the loan will have total access to the money.
CDS index (CDSI) products
Credit derivatives are used to hedge credit risk or to take a position on a basket of credit companies. Contrary to CDS, which is an OTC derivative, CDSI is a standardized credit security.
2. Funded Credit derivatives
This type of agreement involves the borrower making an advance payment to reduce the risk of loss of money to the bank in case of default in future. As a result, the third party is also not exposed to the borrower’s credit risk.
CDOs (Collateralized Debt Obligations) and credit-linked notes (CLNs) are the charmers of funded credit derivatives. In these transactions, SPVs are usually used to issue or raise debt obligations through the seller. Investing in highly rated securities collateralizes the proceeds, and the proceeds can be used for cash or physical settlements.
Here are the top different types of Funded CDs:
Credit Linked Notes (CLN):
Here, the risk is transferred to the investors who take a higher risk for a higher return. If the default does not occur, they get higher returns on these securities. These are also called credit default notes.
Constant Proportion Debt Obligation (CPDO):
It is a type of synthetic collateralized debt instrument that is backed by an index of debt securities. Investors who are willing to take on credit risk can benefit from these credit derivatives.
Collateralized debt obligation (CDO):
This type of asset-backed security (ABS) is structured. The flow of payments is controlled by dividing the CDO into tranches. To compensate for default risk, the lowest tranche pays the highest rates, and the most senior pay the lowest rates.
What are the benefits of a credit derivatives market?
Credit derivatives markets are one of the most popular markets for credit risk transfer. The development of these markets would enhance financial stability since they allow the origination and funding of credit to be separated from the efficient allocation of credit risk.
Credit risk will likely be dispersed to non-bank investors with long holding periods, including insurance companies and investment funds.
Having more diversified credit portfolios will reduce banks’ vulnerability to price shocks. The supply of credit to borrowers will be less dependent on their willingness and ability to take credit risk if they can transfer credit risk more easily.
International banks, securities firms, and potentially insurance companies may face further increases in off-balance sheet exposures as credit derivatives markets grow.
What are the disadvantages of such markets?
These markets are largely unregulated. This leads them open to misuse and may cause macroeconomic troubles. The 2008 depression after the fall of Lehmann Brothers was a result of such misuse.
Unlike stocks or bonds, CDs do not have any underlying financial instruments. It is simply a contract to swap default risk on a third-party loan. In India, Tata Capital offers a Debt Syndication service, acting as a link between the Debtor and the lender. A good CIBIL Score for a personal loan can help you overcome any difficulty that you may face due to a lack of money. So, keep in mind to check your CIBIL score before you apply for a personal loan.