What is a credit derivative?

A credit derivative is a special type of agreement between two groups, called “parties”. The first party gives the second party money. In exchange, the second party promises to pay back the first party if a borrower they chose does not repay their loan. This might sound confusing, but do not worry – we will explain it more!

Understanding credit risk

Have you ever let a friend borrow money and then felt nervous about whether they would pay you back? Big banks and investors who lend out a ton of cash have these same worries. When they lend someone money, there is a chance that person will not repay the loan. The banks call this possibility “credit risk”.

How credit derivatives work

The big lenders who are worried about credit risk sometimes use credit derivatives to protect themselves. It works like this – the lender makes a deal with another party who agrees to pay them if the borrower does not repay the loan. So if the borrower defaults (meaning they do not pay back what they owe), the lender gets money from the other party in the derivative agreement. This way the lender has a backup plan and will not lose all their cash.

Most of the time, credit derivatives are not bought and sold on a big exchange like stocks. Instead, the two parties work out the details of the contract privately between themselves. This is known as an “over-the-counter” deal.

Common types of credit derivatives

There are quite a few different flavors of credit derivatives out there. Each one has its own unique (and often very confusing) name. Let us go over some of the most widespread types:

Credit default swaps

Credit default swaps, or “CDS” for short, are the rock stars of the credit derivative world. They are the most common type. A CDS works like an insurance policy on a loan. The buyer pays the seller a premium over time, and in return, the seller agrees to pay up if the borrower defaults. The buyer is basically betting that the borrower will not repay, while the seller is betting that they will.

Total return swaps

In a total return swap, the buyer receives all the money that a borrower repays on their loan. But in order to get this cash, the buyer has to pay the swap seller a fixed rate (kind of like an interest payment) over time. The buyer profits if the borrower’s repayments add up to more than the fixed rate they are paying the seller.

Credit spread options

With a credit spread option, the buyer has the right (but not the obligation) to buy or sell a bond at a specific price on a certain date in the future. They are essentially betting that the gap (or “spread”) between the price of this bond and the price of another bond will change in a way that earns them money.

Basket swaps

In a basket swap, a bunch of regular credit default swaps (where each CDS covers an individual borrower) are bundled together into a single package. The buyer of the basket is trying to hedge the risk that any of the borrowers in the whole group will default, rather than just a single borrower.

Why lenders use credit derivatives

Credit derivatives have gotten super popular with banks and investors as a way to manage credit risk. There are a few key reasons for this:

Customization

Since credit derivatives are private deals between two parties, the buyer can customize the terms to fit their specific needs. For example, maybe they only want protection against certain types of borrower defaults, or they want bigger payouts in particular situations. Regular insurance policies are one-size-fits-all, but with derivatives, the buyer can tailor the contract to their liking.

Leverage

Credit derivatives allow lenders and investors to take on way more risk than the amount of cash they actually put up. For instance, a bank might only pay a few million dollars for a credit default swap, but that CDS could protect them against the risk of a $100 million loan going bad. If the borrower defaults, the bank gets a huge windfall relative to their initial investment. Derivatives amplify potential profits (but also potential losses).

Capital requirements

Normally, banks have to hold a certain amount of cash in reserve in case some of their loans default. But if they buy credit derivatives to protect against those defaults, the banks can set aside less cash. This frees up more of the bank’s money to go out and make additional loans (which generates more profit). Of course, this also means the original credit risk from those loans gets spread around the broader financial system.

Criticisms of credit derivatives

Ever since the 2008 financial crisis, credit derivatives have gotten a pretty bad rap. There are a few reasons folks are skeptical of them:

Massive complexity

Credit derivatives are mind-bogglingly complicated. Even the experts often struggle to fully grasp how they work. Famed investor Warren Buffet once called derivatives “financial weapons of mass destruction”. The Byzantine complexity of these instruments makes it easier for shady business to go unnoticed.

Systemic risk

When a lender buys a derivative, they are betting that a borrower will not default. But if too many borrowers default at once, the fallout can ripple across the entire financial system. This is exactly what happened in 2008 – all those complex derivatives actually amplified the crisis as they spread risks to every corner of the economy.

Moral hazard

Some critics argue that credit derivatives change lenders’ incentives for the worse. If a bank knows it can just offload its credit risk onto someone else, it might be tempted to make reckless loans it otherwise would not. A bit like how someone with really good health insurance might be more prone to engage in risky behaviors.

Speculation

A lot of players buy credit derivatives with zero intention of hedging any real-world loans. Instead, they are just gambling on the odds of certain borrowers defaulting, in order to make a quick buck. Many experts worry that this kind of rampant speculation makes markets more volatile and unstable for everyone.

The verdict on credit derivatives

At the end of the day, credit derivatives are a complex financial tool that have both benefits and risks. When used responsibly, they can help lenders manage their exposures and free up capital. But when abused, they can encourage risky behavior and exacerbate economic instability.

The 2008 financial crisis revealed the ugly side of the credit derivative market. But it also spurred new regulations to try to rein in some of the excesses. The jury is still out on whether these reforms have done enough to defang the dangers while preserving the useful functions of credit derivatives. Like most powerful innovations, they have the potential for both good and harm – it all comes down to how judiciously they are wielded.

One thing is certain – love them or hate them, credit derivatives are now a central part of the fabric of modern finance. Anyone trying to make sense of the world economy needs to have at least a basic grasp of these esoteric yet influential instruments. Hopefully this overview brought you a few steps closer to understanding how credit derivatives work, where they came from, and the debates surrounding their role. The rest of the story is still unfolding!