Credit default swaps do not have a very good reputation among financial officials. There have been repeated opinions that CDS distort the economic picture in a negative direction. What is it and why is the increase in their value so significantly bothering market participants?
Appearance story
The very first credit default swap in history appeared in 1990 thanks to the joint efforts of Bankers Trust and JP Morgan. The need for its appearance was due to protection against risks for large corporate loans that were provided to the company's customers. Initially, the tool had a relatively small volume, then by the end of the 1990s it was already equal to several hundred billion dollars, and now it has grown rapidly to 28 trillion dollars.
What role do they play?
If you explain the credit default swap on your fingers, then it is a special form of bond insurance, due to which the buyer gets the opportunity to transfer to the investor the risk of default of the borrower on interest payments. Prices for such insurance are measured in hundredths of a percent or in basis points.
For example, if a credit default swap is traded at a cost of one hundred basis points, this means that protecting 10 million dollars of bonds will cost 10 thousand. Such a transaction (swap) provides a certain guarantee at a bargain value.
How it works?
Each of the credit default swaps of European origin is created under a “master agreement” issued by the International Swapsand Derivatives Association (ISDA). It unites all the largest investment banks, as well as other investors in over-the-counter derivatives. Such conditions are very important because credit default swaps are not available on organized exchanges. At their core, they act as a result of an agreement between sellers and buyers, which are investors and investment banks.
How do CDS work?
The International Association of Swaps and Derivatives has five regional committees composed of large investors and banks. This is due to the fact that the concept of a credit event and default is quite difficult to determine. The above committees are the final arbitrators in this matter.
It works as follows. Any investor has the opportunity to send a request to the committee, which will be accepted without fail. Next, the question will be examined whether there is a credit event and whether a transaction can be completed.
Swap in the modern economy - what could go wrong?
Since this financial instrument is contractual in nature, there are too many factors that need to be taken into account, and many instructions. The most important component is that credit default swaps are conditionally based on the borrower or assets. If the underlying asset changes its name, the consequence may be a denial of payment on CDS. A large number of investors faced this fact during the onset of the financial crisis, when some large banks went bankrupt.
Today, most investors are interested in finding a new generation of financial instruments to invest their resources. This is what determines the growing popularity of credit default swaps. According to experts, the default swap on loans is of great importance in modern conditions.
CDS in the USA
Over the past years, credit default swaps have become the most demanded in the United States, due to a sharp increase in credit risks. Since this tool is not under the control of exchanges or government agencies, it is impossible to obtain reliable information regarding the volume of their turnover. As ISDA assesses this situation, hedge funds most actively traded default swaps after the 2008 crisis, and at present the situation is undulating.
Earlier, financiers from around the world practiced numerous speculations regarding default swaps. The result of these actions was the collapse of some significant financial institutions. Many large banks and insurance companies have actually been busted due to operations with CDS.
Credit default swap in Russia
Let's look at what is happening today. Note that credit default swaps in Russia have not gained the same popularity as abroad. This is explained by some problems that must be solved with the help of the experience of other countries. Since the trade in default swaps had a gradual formation, their distribution on the market in Russia is somewhat difficult.
The main circumstance preventing the spread of CDS in Russia is the peculiarities of the structure of the borrowing market. In fact, it turns out that demand for credit resources significantly outstrips supply, and this gives banks the opportunity to set their own terms and conditions regarding rates and terms. The Russian borrowing market has a certain tendency associated with the development of short-term loans offering a fixed rate. In turn, the floating rate is present only in loans issued for long periods (from one year or more), and such loans can be provided exclusively to borrowers who have a good credit history. In addition, only large banks are involved in this. All this indicates that there are problems regarding hedging the risks of change. In addition, the high-quality formation of the CDS market in Russia may have obstacles in the form of speculation with derivatives, which has already been observed in other countries and has had negative consequences.
Despite the fact that the assessment of credit default swaps, as well as their reputation, is very mixed, participants in the Russian financial market are optimistic about their distribution. This is understandable, as holders of debt securities will be able to minimize credit risks, as well as release funds reserved for loans. This will be possible due to the fact that after the purchase of the swap the risk of non-return of funds will be borne by a third party. All this in the long term can increase the liquidity of the debt market as a whole. Sellers, in turn, will get the opportunity to earn extra money by issuing derivatives.
The conclusion from all this can be drawn as follows: credit default swaps can be successfully introduced into the Russian market, however, for this it will be necessary to carefully regulate and systematize their trade. In addition, it is necessary to create conditions for the emergence of mass interest in CDS as a quality tool for hedging against default, and not as an object of speculative resale.