Credit default swaps (CDS) are getting a long-overdue overhaul today.
If all goes well, CDS will have greater transparency, better pricing, and be fully collateralized. More needs to be done, but this is an important first step for an industry that is trying to clean up its (much-sullied) act.
CDS: a primer.
1) With CDS, you are buying protection against the default of a creditor.
2) CDS typically have a 5 year duration, and typically have a $5 million notional value.
3) You pay by making quarterly payments to the provider of the protection.
4) The pricing is in basis points (1 basis point is one-hundredth of one percent), which is how you determine the quarterly payment.
5) In the event of a default, and the buyer of protection demands payment, the buyer would surrender the bonds of the company, and the company selling the protection would pay the difference. So, for example, if the bonds of the company were trading at 80 cents on the dollar, the buyer of protection would surrender the bonds and the seller would pay the cash equivalent of the 80 cents on the dollar; the remaining 20 cents would come out of the seller's pocket.
There are 4 kinds of CDS:
1) Index trade—these are baskets of CDS, typically 125 companies combined. They are cash settled at the end of the term (5 yrs). That is a relatively simple product and is already clearing at ICE Trust.
2) Single names-CDS on Ford , GE , etc. They used to be physically delivered, so at the end of the term you would deliver the bonds. These are the ones that are changing today.
3) Traunch CDS, where the risk is stripped into traunches, much like a Collateralized Debt Obligation (CDOs). The idea of taking deriviates and segregating them into pools of risk has been discredited, so while these still exist there are very few new ones being written.
4) CDS tied to mortgage securities or other single-purpose debt vehicle, which are being restructured.
What's changed today: how the single name CDS will trade.
1) The pricing which is paid on a quarterly basis will be standardized. The upshot of all this is that the CDS will begin trading more like the underlying bonds of the companies, in the sense that there will be standard coupons.
2) From now on they will be cash settled in a single auction. The industry has agreed to hold an auction immediately after the "default event" which would determine the pricing of the underlying defaulting bonds.
This is a critical change, because in the past, you might have to wait until the bankruptcy was completed before you got your money. The creditors would argue with the company, and endless disputes occurred.
An immediate auction settles the matter quickly.
3) The industry has agreed to a strict definition of what constitutes a "default event" so you know what kind of protection you are buying. In the past, there were arguments over whether a default occurred, for example, a debt restructuring on the eve of a bankruptcy.
Clearing: the next step. In the next few weeks, the single-name CDS will also begin clearing on the ICE Trust.
What clearing does is the clearinghouse becomes the buyer to every seller and the seller to every buyer: there is no more counterparty risk because the clearinghouse assumes the counterparty risk.
The clearinghouse requires collateral against every position, so you cannot have unhedged, unfunded CDS out there.
The clearinghouse also marks everything to market, so it creates greater transparency because everyone agrees on the right price.
What about listing on an exchange? This is the next step: the bid-offer spread is still huge on these, but the government wants more transparency, so this will be coming soon.
Should CDS be allowed at all? I've heard it said that CDS should not be allowed because it creates additional levels of speculation: you do not need to own the underlying debt of the company to take out protection (CDS) on it.
In this sense, it is not "insurance," i.e. you're not taking out protection on something you own.
The argument in favor of being able to do this is that your company can be affected by the credit quality of others even if you don't own the debt. If you are Ford for example, and GM goes bankrupt, Ford's cost of borrowing will go up. If you are Ford, you might want to buy protection against that event, even if you don't own GM.
Also, with almost everyone you do business with, you have some kind of payment risk. So if you can buy protection against their defaulting and you becoming a creditor, that is a valid risk management tool.
One other point: a regulated, transparent CDS market could replace rating agencies. I might have the best equity thesis in the world, I might know a lot about a company, but it could be derailed by a credit event that I didn't know about.
So CDS is starting to take the place of the rating agencies, because lenders are starting to price debt to companies against the market value of CDS.
Today, at 3:20 PM ET on Closing Bell, I will have Jeff Sprecher, CEO of the Intercontinental Exchange, as my guest to discuss the new rules.
Questions? Comments? firstname.lastname@example.org