What is a CDS?

A CDS is a financial contract between two parties that functions like insurance against defaults on debt obligations (bonds, loans) [1]. Here's a breakdown of how it works:

Mechanics of a CDS Contract:

? Parties Involved:

? Protection Buyer: The party purchasing protection against default on a specific debt obligation (bond, loan, etc.) They pay a premium to the seller.

? Protection Seller: The party agreeing to compensate the buyer if the debt obligation defaults. They receive the premium from the buyer.

? Key Elements:

? Reference Entity: The issuer of the debt obligation the CDS references (e.g., a company or government).

? Reference Obligation: The specific debt security (bond, loan) covered by the CDS.

? Notional Amount: The face value of the debt obligation used to calculate the premium and potential payout.

? Premium: The periodic payment made by the buyer to the seller, typically a percentage of the notional amount. This cost reflects the perceived risk of default by the reference entity.

? Maturity Date: The date the CDS contract expires.

? Trigger Event: The specific event(s) considered a default under the contract, such as bankruptcy, missed interest payment, or restructuring.

? Payout Determination: The method for determining the compensation received by the buyer if a default occurs. This often involves the difference between the notional amount and the recovered value of the reference obligation after default. Settlement can be through cash payment or delivery of the defaulted security.

Types of CDS Contracts:

? Single-Name CDS: Protects against the default of a single reference entity.

? Basket CDS: Provides protection against defaults of multiple reference entities within a specific basket (e.g., companies in a particular industry).

? Index CDS: Tracks the creditworthiness of a bond index, offering protection against defaults within the index.

Uses of CDS Contracts:

? Hedging: Mitigating credit risk by transferring the risk of default on a held security to another party. (e.g., An investor holding a corporate bond can buy a CDS on that bond to protect against default).

? Speculation: Betting on the likelihood of default by a particular entity. (e.g., An investor believing a company is likely to default might buy a CDS on that company's debt, profiting if a default occurs).

? Arbitrage: Exploiting price discrepancies between CDS contracts and underlying securities.

Criticisms of CDS Contracts:

? Opacity: The complex nature of CDS contracts can make it difficult to assess overall market risk.

? Potential for Systemic Risk: Large, interconnected CDS positions could exacerbate financial crises if defaults occur.

? Misuse for Speculation: CDS contracts can be used for speculative purposes, potentially amplifying market volatility.

Regulations:

? The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) introduced regulations for CDS markets in the US, aiming to increase transparency and reduce counterparty risk.

Credit Default Swap (CDS) Successions Explained

What is a Succession Event in a CDS?

A succession event occurs when a significant amount of debt obligations (typically more than 25%) from the reference entity (the company whose security the CDS references) are transferred to one or more successor entities through events like mergers, spin-offs, or acquisitions [1].

How Does a Succession Event Impact a CDS Contract?

? The key question is: Who becomes the new reference entity for the CDS contract?

? The answer depends on several factors:

? The CDS Contract: The contract itself should have a clear definition of a succession event and outline the process for handling it [1, 2].

? ISDA Determinations: The International Swaps and Derivatives Association (ISDA) provides guidelines and determinations for handling succession events when the contract language is unclear [1, 2]. These are not binding but hold significant weight.

? Legal Opinions: In complex cases, legal advice may be sought to interpret the contract language and determine the successor entity [3].

Possible Outcomes of a Succession Event:

? No Change: If the debt transfer is minor, the CDS may continue referencing the original entity [2].

? Partial Transfer: The CDS contract may be partially transferred to one or more successor entities based on the proportion of debt they assume [2].

? Full Transfer: The entire CDS contract may be transferred to a single successor entity that assumes most of the debt [2].

? Termination: In rare cases, the CDS contract might be terminated if the succession event significantly alters the reference entity or its obligations [3].

Challenges and Considerations:

? Clarity in the Contract: Clearly defined succession clauses are essential to avoid disputes about the successor entity and how the CDS contract applies after the event.

? Negotiating the Clause: When entering a CDS contract, consider negotiating the following in the succession clause :

? Specific definition of a succession event and debt transfer threshold.

? Allocation of rights and obligations among potential successor entities.

? Early warning provisions for potential succession events.

? Determining Successor: There could be disagreements between the buyer and seller on who the true successor is, especially in complex transactions.

? Valuing the Successor: Assessing the creditworthiness of a new successor entity, particularly in spin-offs, can be challenging.

? Market Disruption: Uncertainties surrounding succession events can lead to temporary price swings in the CDS market.

Recommendations:

? Carefully review the succession clause in a CDS contract before entering into it.

? Consider seeking legal advice for complex situations to ensure a smooth transition in case of a succession event.

? By understanding succession events and their implications, both CDS buyers and sellers can manage risk more effectively and make informed decisions.

The CDS Market and Insider Trading:

? Historically, the large size and lack of regulation in the CDS market raised concerns about potential insider trading.

? The example of private equity acquisitions highlights how some may have gained an unfair advantage by buying CDS on target companies before the announcement, profiting when the buyout increased default risk.

The AIG Bailout and CDS:

? AIG, a major seller of CDS protection, suffered significant losses due to the 2008 financial crisis and required a government bailout.

? This event highlighted the potential systemic risks associated with a large, unregulated CDS market.

Mitigating Risk with CDS Contracts:

? Clear Succession Clauses: Clearly define what constitutes a succession event (e.g., merger, spin-off) and how the CDS contract applies in such scenarios.

? Standardized Contracts: Standardized elements like upfront payments and annual fees can reduce ambiguity and disputes

Regulating the CDS Market: Transparency and Reduced Risk

The unregulated CDS market raised concerns due to its potential for instability. To address this, several key actions were taken:

? Centralized Clearinghouses: InterContinental Exchange, CME, and Citadel established clearinghouses specifically for CDS transactions. Shifting these transactions to central hubs increased transparency and reduced counterparty risk, making the market more secure.

? Standardized CDS Contracts: The International Swaps and Derivatives Association (ISDA) played a vital role by standardizing CDS contracts. This included setting standard fees (upfront payments and annual fees) which not only improved transparency but also helped prevent legal disputes arising from contract ambiguities.

These combined efforts aimed to make the CDS market more transparent and less risky, promoting greater stability in the financial system.

Additional Considerations:

? Counterparty Risk: The risk that the seller may not be able to fulfill their obligation in case of a default.

? Market Volatility: CDS prices can fluctuate significantly based on market sentiment and perceived default risk.

By understanding these aspects, you can gain a more comprehensive understanding of Credit Default Swaps and the potential benefits and risks associated with them.