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Note: This Learning Curve examines why central counterparties might consider permitting issuers of bonds to write credit default swaps on themselves.
This Learning Curve examines why central counterparties might consider permitting issuers of bonds to write credit default swaps on themselves.
Laypeople and those in the finance world alike have become familiar with the credit default swap (CDS), an instrument that is a popular and useful derivative for a wide variety of investors and hedgers worldwide. CDS are used for a multitude of purposes, including to hedge the credit risk of bonds, to evaluate the financial health of an entity, and to gain exposure to changes in the credit risk of an entity.
Over the past year, various Senators and representatives of U.S. Congress have put forth proposals recommending an increase in the regulation of CDS, which could have significant effects on its uses in various arenas. One salient thread in most of the proposals is that all standardized CDS be cleared through one or more central counterparty (CCP). As these central counterparties develop their CDS policies, this article poses one question for consideration: should those central counterparties permit issuers of bonds to write CDS on themselves? As of press time, nothing has been uttered from financial regulators on the matter. That this question is being posed might seem absurd to some readers, but the question is not as curious as it might seem on first blush.
Posit the following hypothetical situation involving two companies: Company A and Company B. Company A is AAA-rated and Company B is BBB-rated, or, alternatively (for those holding less stock in the value of credit ratings), assume that the spread of CDS on Company A is currently lower than the spread of CDS on Company B. Assume further that, if Company A defaults on its debt, it will default on all of its other contractual obligations, which include margin calls on CDS it has written. (For the purposes of this article, it is assumed that CDS are only triggered upon a company's failure to make payments on its debt,...