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					Credit Default Swap:
Protection or Speculation?
   Introduction of credit default swap (CDS)
   CDS Market Growth & Development
   Usage of CDS
   How CDS created chaos
   Regulation of CDS
   Conclusion
A credit default swap (CDS) is a credit
derivative contract between two
counterparties. The buyer makes periodic
payments (premium leg) to the seller, and in
return receives a payoff (protection or default
leg) if an underlying financial instrument
Brief History of CDS
   Credit Default Swaps were invented in 1997
    by a team working for JPMorgan Chase.
   They were designed to shift the risk of
    default to a third party, and were therefore
    less punitive in terms of regulatory capital.
Brief History of CDS
   Credit Default Swaps
    became largely exempt
    from regulation by the
    SEC and the CFTC with
    the Commodity Futures
    Modernization Act of
   President Clinton signed
    the bill into Public Law
    (106-554) on December 21,
   Held $440 billion
   of CDS before
   bailed out.

   Defaulted on $14
   billion worth of
   CDS.
Had itself made more than $700 billion worth
of credit default swaps, and many of them
were backed by AIG
CDS Market Growth & Development
CDS Market Growth & Development
    CDS Market Growth & Development
   Single-Name CDS
   Binary CDS
   Cancellable CDS (callable or
   Contingent CDS
   Leveraged CDS
   Multi-Name (Basket) CDS
CDS Market Growth & Development
Usage of CDS
   CDS contracts have been compared with
    insurance, because the buyer pays a
    premium and, in return, receives a sum of
    money if a specified event occurs.
   However, there are a number of differences
    between CDS and insurance.
Usage of CDS
   The buyer of a CDS does not need to own
    the underlying security or other form of
    credit exposure; in fact the buyer does not
    even have to suffer a loss from the default
    event. By contrast, to purchase insurance
    the insured is generally expected to have an
    insurable interest such as owning a debt.
Usage of CDS - Hedging
   The holder of, for example, a corporate bond
    may hedge their exposure by entering into a
    CDS contract as the buyer of protection.
   If the bond goes into default, the proceeds
    from the CDS contract will cancel out the
    losses on the underlying bond.
Usage of CDS - Speculation
   Investor might believe that an entity's CDS spreads are either
    too high or too low relative to the entity's bond yields.
   Basis trade : combining a CDS with a cash bond and an
    interest rate swap.

Company’s credit                    Price of CDS
Usage of CDS - Arbitrage
   A company's stock price and its CDS spread
    should exhibit negative correlation.
   Looking for mis-pricings between a
    company's debt and equity.

Company has                          If CDS spread remains
announced        Stock price drops
some bad news

                                     Long: CDS and shares
How CDS created chaos
Protection for loan, or encourage
of excessive borrowing?
   Emerging market bonds, junk bonds
   Mortgage-backed securities, CDOs
 …everyone in my road buying insurance on my house in the hope that it collapses…
Regulator’s Perspective
   In 2000, New York State Insurance
    Department (NYID) declared that swaps were
    NOT insurance
   In Nov 2008, the Insurance Department
    revisited the decision and reversed it as
   Swaps were divided into two types:
 Regulator’s Perspective
Covered CDS                  Naked CDS

Buyers need to own           Buyers does not need to
underlying obligation        own
Buyer only has a claim       No actual loss is required
after actually suffering a   to trigger a claim
Similar to insurance         Similar to naked shorting
                             of stocks
Regulator’s Perspective
   Covered CDS provided some degree of risk

   Naked CDS created and assumed risks like a

NYID considered ONLY covered CDS as
International Swaps and
Derivatives Association (ISDA)’s
   “Big Bang” Protocol
     Certainty   - Adds Auction as a settlement
     Consistency – The Determinations Committee

     Enhanced Transparency – Information
     Liquidity – Standardization by the use of fixed
Standardize transaction and relax the
 public concern
Recent Updates
   Starting from January 1, 2009, New York
    Insurance Department regulated covered CDS
    market by requiring the CDS seller to have an
    insurance license

   Criteria is based only on whether the buyer
    own the underlying securities that the CDS
Recent Updates
   Feb 2009 – a discuss draft of the Derivatives
    Markets Transparency and Accountability
    Act of 2009 in the U.S. House of
     Section 16 – Prohibition of Naked CDS
     Section 13 – Clearing of OTC Transactions
Recent Updates
Why central clearing system is
   Under the bilateral system in the
    previous slide, “Duplicate” CDS
    contracts would be produced in order
    to hedge the counterparty risk.
   For example, A purchased CDS
    contract issue by D. To avoid loss due
    to potential credit event of D, A may
    also engage CDS contract regarding to
    D with another financial institution E.
    And many financial institutions
    including investment banks,
    commercial banks, insurance
    companies, hedge funds etc were
    actually repeat such process in the past.
   This is one the major reason that CDS
    market has become a huge monster in
    terms of face value of the contracts.
Why central clearing system is
   A CDS central counterparty (a "CCP") interposes
    itself between each of the counterparties to a CDS.
   It is seen as necessary to the containment of the
    failure of a major market participant.
   The CCP is able to position itself as central
    counterparty by demanding collateral from
    participants in the clearinghouse based on daily
    marks of their positions.
   Therefore, the benefit of a CDS central counterparty
    is to ensure settlement in the event of a default by a
Why central clearing system is
   This arrangement is similar to the existing margin
    account system for trading activates of future
    contracts and other derivatives by the market
   By implementing such clearing system, the counter
    party risk involve in CDS trading transaction is
    transfer to the CCP.
   However, because membership in a clearinghouse is
    limited only to those able to maintain the financial
    standards of the clearinghouse, it is quite possible
    that any weakening credit will be excluded from a
    clearinghouse prior to any potential payment default.
Why central clearing system is
   The CCP therefore can be also expected to
    provide greater transparency generated from
    the prices, volumes and open interest
   Overall speaking, implementing such CCP can
    reduce systematic risk by maintaining
    financial standard of CDS market.
   It seems the government aims at regulating CDS
    market through changing the nature of the contract
       Requiring insurable interest
   Market participants on the other hand focus more on
    advancing current market practice and relieving
    public anxiety
       Unwind positions that can be cancelling each other
       Standardizing contract terms

   No comprehensive agreement about reform
    between the government and the market dealers
   NYID’s review was based on two important
    insurance principles:
    -   Presence of Insurable Interest
    -   Principle of Indemnity

   In fact, CDS is different from a traditional
    insurance in many other aspects like:
CDS versus Insurance
                 Insurance   CDS

Insurable         Yes        No
Seller is a       Yes        No
regulated entity?

Principle of     Yes         No
CDS versus Insurance
                 Insurance        CDS

Ways of          Reduce total risk Hedging
managing risk    by Law of Large e.g. offsetting
                 Numbers           CDS with other
Accounting       Mark-to-model     Mark-to-market
Tradable          No              Yes
Reserve required? Yes             No
Should CDS be held / written by
insurance company?
   There are 2 types of concerns:

   Purpose

   Pricing / Valuation
Should CDS be held / written by
insurance company?
   Purpose:
   Why an insurer need to hold/write a CDS?

   Covered / Naked CDS?

   Any other alternatives?
Should CDS be held / written by
insurance company?
   How a CDS be priced?
   Mark-to-model?
     Probabilitymodel?
     No-arbitrage model?

   Both are difficult to be
    integrated into existing
    insurer’s valuation
Should CDS be held / written by
insurance company?
   Mark-to-market asset?

   Mark-to-market liability?

Excess volatility in insurer’s income
 statement and balance sheet
   Traditional credit insurance products provides
    protection of business operations and reduce total
    market risks on an effective manner
   Some new credit products, like CDS, covers risks that
    are not fully understood and modeled in the moment
   These products are also criticized by encouraging
    moral hazards and excessive borrowing and lending
    in the capital market
   Stricter regulations should be imposed to
    financial institutions holding these new
    insurance-like credit products, such as high
    reserve requirements
   On the other hand, regulators should keep
    frequent reviews on market products and
    update their underlying structure and
    mechanism in order to prevent any
    misleading to investors
    BBC Newsnight feature by Alex Ritson on Credit Default Swaps,

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