Buy now, pay sooner – dynamic discounting

| 12-04-2018 | Lionel Pavey |

 

We live in a time of very low interest rates which translates to lower funding costs. However, at the same time, obtaining credit is becoming more difficult as banks are reluctant to lend in the ways that they did years ago. This is caused by the need for additional financial buffers to comply with all the regulatory issues that surround modern day banking. Credit is still available via other avenues – look at P2P lending for example. When all else fails, it is necessary to look at one’s own internal supply chain to see how financing can be facilitated. Here is a report on the practice of dynamic discounting.

Dynamic discounting

As a corporate is common to purchase goods and services on the basis of receiving an invoice and paying at a later date. It is normal to see invoices stating that payment must be made within 30 days of the invoice date – not the acceptance date. As an incentive to pay the invoice early many companies offer a discount – the classic example is called 2/10 net 30. Breaking down this code shows that a 2 per cent discount is offered on the face amount of the invoice if it is paid within 10 days of the invoice date, otherwise payment is expected within 30 days.

Whilst 2 per cent might not sound very tempting, we need to look at the mathematics that lie behind this:
On an invoice for EUR 1,000 this means a discount of EUR 20. If we decided not to use the discount and only pay after 30 days we would have held onto our EUR 1,000 for an extra 20 days – this being the difference between the early payment date and the standard payment date. At present, we might make 1 per cent interest per annum on our bank account. The interest earned on EUR 1,000 for 20 days at 1 per cent, would reward us with EUR 1.11 – or, put in other words – EUR 18.89 less than if we paid early.

Why offer a discount?

• The supplier wants to lower their banking costs and improve their ratings
• The supplier needs the money
• Banks are not willing to lend money to the supplier
• The supplier is worried about their level of exposure to credit risk and counterparty risk
• It gives a supplier a useful insight into the business practices of their clients – if they calculated the advantage of taking the discount and declined, could there be inherent problems with the financial health of the client

Also, generating your own internal supply chain finance operation lessens the reliance you have on external funding from banks or factoring agencies.

A more modern adaptation of this practice is the development of discounts that are truly dynamic and work on a sliding scale. The highest discount is given for the fastest payment, and then progressing down in stages till the original invoice settlement date. This gives buyers an opportunity to still receive a discount, but not being tied down to the original 10 day period.

Irrespective of the financial gains offered by discounting, a more important aspect is positive growth in the working relationship between supplier and client. By supporting each other the bonds of trust increase and can lead to new and better opportunities together.

If you are interested to know what the effect of these changes can be on a coupon payment and calculation, please contact us for more detailed information.

Lionel Pavey

 

Lionel Pavey

Cash Management and Treasury Specialist

 

Basis Swap – how to convert your exposure

| 10-04-2018 | treasuryXL |

At the moment, there is a growing movement within interbank markets to replace all the existing interbank offer rates that are used to price a myriad of financial instruments. The motivation for this movement has been the revelation that these indices have been fraudulently priced by banks delivering inaccurate prices for the daily fixing. At the moment the markets are first looking at secured overnight lending indices – but these are not complimentary to all the existing instruments that regularly reference a longer tenor on an unsecured basis. These can lead to problems with the asset and liability management of a portfolio – not just for banks, but also for corporate clients.

So, what is a basis swap and how does it work?

A basis swap is an interest rate swap where both legs reference a floating rate – either in the same currency or on a cross currency. Examples would be a 3 month Euribor exposure against a 6 month Euribor exposure, or 3 month USD Libor versus 3 month GBP Libor. In a normal positive yield curve the interest rate for a longer tenor is higher than for the shorter period – 3 month USD Libor is 2.33746% and 6 month USD Libor is 2.47219%. There are 2 main reasons for the difference in price – the tenor is longer, therefore the risk of repayment is lengthened and the individual credit rating of the counterparty is also affected.

Before the financial crisis of 2008, basis swaps were traded, but not given much attention. Their primary function was for transforming the asset and liability management in the same currency. It was actively used in the cross currency market where a bank might raise long term funds in Japanese Yen, but needed to convert the proceeds into USD. Furthermore, the consensus at the time was that 1 master curve could be built to price all products – this used short dated deposits, 3 month interest rate futures and long date interest rate swaps to build the single curve.

This meant that a 6 month deposit was built on the basis of a 3 month deposit and a 3m v 6m FRA (Forward Rate Agreement) . In such an instance there would be no arbitrage possible and the market did not really look at the basis risk. But the basis risk was inherent and certain market players exploited this misconception – particularly banks that received fiduciary funding via Switzerland.

Today, there is far more awareness of the basis risk. 3 month Euribor is -0.329% and a 3v6m EUR FRA is -0.33/-0.31%. However the 6 month Euribor is 0.270% (we will leave you to do the calculation)

As a longer tenor has a higher interest rate (in normal market conditions) a basis swap referencing a 3 month versus 6 month payment would see the 3 month period being quoted as flat rate plus a premium, and the 6 month period being shown as a flat rate. A typical quotation for a 1 year EUR basis swap referencing a 3 month against 6 month Euribor would be priced around at about 5 -6 basis points premium. This means if you were to pay the shorter period of 3 months you would pay the base of 3 month Euribor plus 5-6 basis points every 3 months for 1 year, against receiving the 6 month Euribor flat every 6 months.

This product allows you to transform your position, but also gives insight into how the market sees the continuous 3 month and 6 month curves, together with their inherent basis risk.

An interest rate swap curve that references a 6 month floating leg, will normally be built from an interest rate swap curve built off a 3 month floating leg, with an adjustment for the 3m v 6m basis swap to reflect the higher price on a 6 month curve.

 

1 year to Brexit – the banking exodus?

| 09-04-2018 | treasuryXL |

If all goes as stated, then the United Kingdom will be leaving the European Union on 29th March 2019. There has been fierce competition within the EU to entice banks away from London and to settle within the Euro zone. In London there is a fear that there will be a banking exodus –  an industry that has prospered and made London a global centre. At till now banks have been able to sell their services into Europe via London, that this is envisaged to change. So, how are the major European cities faring in their campaigns?

What is at stake?

The scenarios of job losses are varied – 10,000 job in banking, 20,000 in further financial services. Others speak of job losses totaling more than 200,000. The large US investment banks retain more than 80 per cent of their European staff in London. The main target appears to be the Euro clearing role – a settlement service mainly in financial derivatives denominated in Euro’s that is now performed in London.

The Netherlands has certainly tried to attract interest from foreign banks and has many good qualities. Most of the population speak English, and there is a good infrastructure. Tax incentives are offered to qualified foreign workers, together with a global port in Rotterdam. The Netherlands Foreign Investment Agency is actively engaging with foreign companies, extoling the virtues of the country. Recently, Unilever took the decision to place its headquarters in Rotterdam – even though they have had a head office there for close on 100 years. Whilst there is already an appreciable physical presence of foreign banks on Dutch soil, there have yet to be any big announcements about a bank moving from London to Amsterdam or Rotterdam.

Germany, and specifically Frankfurt, have also been hard at work. The economy minister for the state of Hesse, claims that more than 20 financial institutions have chosen for Frankfurt. As of today, their names have not all been revealed. Frankfurt is an established financial centre, though discernably smaller than London. As well as banks, there are also regional corporate treasury centres, prime brokers, legal services and other ancillary groups.

Paris – that has been chosen for the European Banking Authority – is also in the picture but does not appear to be attracting the financial institutions. If banks follow the London model, then they would rather be closer to the central bank – the ECB – and that is headquartered in Frankfurt.

Relocation of the financial industry from London to Europe will be good for local employment. It is not just the direct banking industry that will be of benefit to the local communities. The support services are very significant and must also be factored into any equation.

With now less than 12 months to go till Brexit, the race will be heating up to woo the banks as the prize is very enticing and the gains to local economies very large!!

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State of the nation – the future looks bright

| 06-04-2018 | treasuryXL |

Last week, the Centraal  Bureau voor de Statistiek (CBS) released their year end data for 2017 regarding the Dutch economy. The recovery is strong – for the first time since 2008 the Netherlands complies with 2 of the important Euro criteria at the same time; the government debt is below 60% of GDP and the annual budget deficit must not exceed 3% of GDP. Furthermore, Dutch GDP grew at an annual rate by 3.2% in 2017 – this is higher than in 2016 when the growth was 2.2%. This is the strongest growth since 2007. We take a look at the data and the contributing factors.

Debt

At the end of Q4 2017, government debt was reported as EUR 416 bn. This is 56.7% of GDP, compared to 61.8% in 2016. There was a reduction of EUR 18 bn in the total debt – the largest annual fall recorded. As recently as 2014, this ratio stood at 68.0%

Budget surplus

At the end of Q4 2017, the government had a budget surplus of EUR 8 bn – a surplus of 1.1% of GDP. In 2009, this was a deficit of 5.4% of GDP. Expenditure increased by EUR 7 bn in 2017, but this was offset by an increase in revenue of EUR 12 bn. Tax revenues increased by EUR 15 bn. There was additional income of EUR 8 bn from the sale of state shareholdings in ASR and ABNAmro among others.

Inflation

There was a rise in consumer prices – CPI showed an annual rise of 1.4% in 2017. This compares with a rise of 0.3% in 2016.

Labour

Wages in 2017 increased by 1.7% and unemployment fell in 2017 – at the end of 2017 the rate was 4.1%. Shortages of available labour are being observed in the market – employers have stated that they are finding it increasingly hard to find appropriate employees. The latest reports suggest that there are 1 million vacancies, but that employers are having difficulty finding qualified people. Most of this growth appears to be coming from the small and medium sized enterprises (MKB) – large organisations are still in a round of cost-cutting and down-sizing.

The report of the Netherlands looks very rosy, but international events could impact on the health of the economy. There are threats of trade wars; Brexit will impact on trade within 1 year; the EU parliament is asking for more money in the next budget cycle; the composition of the new Italian government could cause unrest within the rest of the EU.

The future does look bright, but caution is advised on the road ahead.

What future role for CSDs in blockchain post-trade environment?

| 05-04-2018 | Carlo de Meijer |

Blockchain technology enables real-time settlement finality in the securities world. This may mean the end of a number of players in the post trade area. For a long time, central securities depositories (CSDs), as intermediators in the post-trade processing chain, were expected to become obsolete. CSDs, but also other existing players in the post-trade environment, are however changing their mind on these new technologies and on their future position in the blockchain world. Increasing regulation, legacy systems and costs pressures, are drivers for CSDs to at least embrace some aspects of blockchain. They are increasingly considering them as enabler of more efficient processing of existing and new services, instead of a threat to their existence. It is interesting to see that some of these actors – who could be potentially big losers in a distributed ledger technology (DLT) or blockchain system – are open to innovation with blockchain and willing to invest in DLT. Last January SWIFT and seven CSDs worldwide agreed on a Memorandum of Understanding to explore the use of blockchain technology in the post trade process esp. e-proxy voting.

Where do CSDs stand now?

Complex and fragmented post-trade infrastructure

The current post-trade infrastructure is highly complex and fragmented, crowded with intermediaries, and dealing with outdated legacy systems and technologies. Much of the complexity and fragmentation of the post-trade world is the result of the various participants (custodians, issuers, registrars, CSDs) holding their own, separate ledgers in order to carry out the processes. Consequently, they spend much time and resources on reconciliation and risk management, in order to ensure that transactions can be (and are) appropriately carried out. The completion of securities transactions is as a result a costly and risky business. This has important consequences, efficiency-wise.

Situated at the end of the post-trading process, CSDs are systemically important intermediaries. In the post-trade process the CSDs play a special role both as a depository, involving the legal safekeeping and maintenance of securities in a ‘central depository’ on behalf of custodians, in materialised or dematerialised form; and for the, involving the issuance of further securities by issuers, and their onboarding onto CSDs’ platforms.

Is there a future for CSDs in a disruptive blockchain world?

Blockchain: disruption in securities post-trade

DLT has the potential to heavily disrupt existing post-trade processes in financial services, impacting the business model of a number of intermediaries. This raises significant questions for the present actors in the post-trade world as their role may change dramatically or even disappear. For some actors in the post-trade world, DLT could completely replace their businesses or even make them obsolete. And others should question what will be their added-value within future DLT services.

With blockchain, that is linking trading partners directly, everything will be in place in the ledger at the time of the transaction. Institutions will no longer have to maintain their own databases in the future with DLT, as there will be only one database for all participants in the transaction.

With DLT, all of the complex systems and processes to transfer cash and equities from one account to another are not required. Everything can be embedded into the blockchain. Buyers and sellers can match transactions in seconds and all parties are aware a transaction has been done. This will heavily ease the reconciliation process. Blockchain could ultimately become the standard for financial transactions and real-time settlements, increasing transparency and efficiency in a highly fragmented industry.

Read the full article of our expert Carlo de Meijer on LinkedIn

 

Carlo de Meijer

Economist and researcher

 

Financing your international trade – documentary collections

| 04-04-2018 | Lionel Pavey |

 

Acquiring the right goods at the right price can eventually lead a company to overseas markets. International trade has certain barriers – buyers and sellers have never met and are reluctant to completely trust each other; drawing up documentation can be difficult and time consuming due to difference in law between 2 countries; agreement has to be made on the settlement currency; documentation that implies ownership needs to be sent, but the seller is hesitant to have these released to the buyer before payment has been made. This article looks at 1 of the 3 main financial instruments used in international trade – the documentary collection (DC).

What is the process?

1 – Buyer and seller agree terms and conditions for a trade to take place – the means of payment, the collecting bank (this is usually the house bank of the buyer), a detailed description of the set of documents that have to supplied.

2 – The seller (exporter) arranges for shipment of the goods to the buyer (importer) via a shipping agent and receives a transport document (usually a bill of lading) that is negotiable.

3 – The seller prepares the agreed documents into 1 package and presents these to his bank (the remitting bank). This will include the bill of lading, certificates of origin, inspection notices, a collection order stating the terms and conditions under which the bank can release the documents etc. and a draft.

4 – The remitting bank will send these documents to the collecting bank instructing the collecting bank to present the documents to the buyer and to collect the payment.

5 – The collecting bank will inspect the documents and the contract, ensuring that they are in compliance with the collection order.

6 – The collecting bank will contact the buyer stating that the documents are in order, or what discrepancies have been established; and inform the buyer about the terms and conditions of the collection order.

7 – The buyer will be shown the documents and asked to accept them. Acceptance is recognised by signing the draft. When the documents are accepted, and payment is made then the documents are handed over to the buyer.

8 – Release of the documents occurs in  2 ways – documents against payment is when payment is made at sight of the documents; and documents against acceptance is when payment is made at an agreed date in the future.

9 – The buyer takes possession of the documents allowing them to receive the goods from the warehouse or port where they are being stored.

10 – The collecting bank arranges to pay the remitting bank either immediately in the event of a sight bill, or at the agreed future date in the event of an acceptance bill.

11 – The remitting bank arranges to credit the account of the seller.

So it is a letter of credit?

No, a documentary collection is an alternative to a letter of credit. In a DC, the banks undertake no guarantee role – they merely advise, release documents and effect payments. If a buyer does not agree to the documents, they do not receive the goods, the banks do not effect payment and the seller is out of pocket. Therefore a DC is normally far cheaper than a LC.

Why use a DC?

Both buyer and seller know each other and are happy with their existing relationship.

The collections are for a one-off transaction – there is no open account between the parties.

The seller has faith in the economic and political characteristics of the importing country.

A LC is not acceptable to both parties.

Documentary collections are governed by the Uniform Rules for Collections as issued by the International Chamber of Commerce.

Lionel Pavey

 

Lionel Pavey

Cash Management and Treasury Specialist

 

TIS – the single source of truth

| 29-03-2018 | treasuryXL | TIS Treasury Intelligence Solutions |

On Tuesday 27th March 2018, treasuryXL attended a seminar in Amsterdam organised by TIS. TIS stands for Treasury Intelligence Solutions and, during this seminar, Christian Werling from TIS  gave a very informative presentation about their services which focus on cloud solutions for managing the administration of bank accounts. These solutions offer real-time reporting on all bank accounts – worldwide – and the ability to use just one system to validate and release all payments. In a world where a treasury department might hold more than 100 bank accounts, dispersed over more than 10 banks spread out across different time zones  and having to maintain the possession and custody of numerous bank tokens and log in protocols, a one stop solution is very enticing.

Why?

In today’s world, companies can find themselves with a physical presence in a multitude of countries and locations. In the current environment, a corporate treasury would need to log on to the website of every unique bank where they hold accounts and extract the bank statements for the previous day. Using separate bank tokens and log in protocols, this process can quite easily take up to 1 hour. Furthermore, all the separate data needs to be collated and then uploaded into 1 system, Various subsets of the information need to be given to different internal departments so that they can perform their daily tasks – reconciliation, data input and verification.

The reality

In the modern age, you could find yourself as a Treasurer, within a large complex organisation, consisting of a head office, subsidiaries, legal entities and shared service centres. The underlying platforms can consist of book keeping systems, ERP, HR and different databases. Additional data flows come from e-banking systems, TMS and stand alone projects. The output from all these systems are then used to connect to the banks. Furthermore, all these layers of connectivity can be subject to fraud or attack from outside sources.

TIS provides a single point of contact via a SaaS (Software as a Service) platform that connects to all these systems, thereby offering a simple and effective control over the data flows in real time.

Advantages

  • Real time information
  • Control from a single point
  • Centralised bank account management
  • Centralised bank account mandates
  • Transparency
  • Cost efficiencies

After this we were informed about how the system works in the real world. Bas Coolen is the global head of treasury at Archroma – a colour and speciality chemicals company based in Switzerland. They have a physical presence in over 35 countries and 3,000 employees. Formed 5 years ago, they wanted a minimal  IT solution to their legacy banking operations. These operations stretch from Asia, via Europe to the Americas and involved many different banks.  They concluded that no single bank could provide the service they required within every country and that they needed a solution. By adopting the platform offered by TIS, they have been able to implement a global system that encompasses all their bank accounts – this provides them with a single source of truth. Importantly, the security aspects can now be maintained from one source – all the relevant authorisation matrices are now contained in one platform, along with the capability to perform all global e-banking operations from one location.

TIS were joined at this seminar by Cashforce, who presented their Smart Cash Forecasting and Treasury system – that will be the topic of our next blog.

treasuryXL would like to thank TIS for allowing us to participate in this seminar. If you have any questions, please feel free to contact us.

 

Rainy day funds and moral hazards

| 28-03-2018 | treasuryXL |

Christine Lagarde – the chief of the IMF – stated recently that the Eurozone countries should set up a “rainy day” fund that could be used to protect the countries in a time of economic turmoil. As the IMF is seen as the lender of last resort to the world, her words carry weight. Economies are subject to a cyclical motion – going from bad to good and then back down again. Her opinion is that closer integration is needed between the Eurozone countries to protect them from the inevitable downturn when it arrives.

Closer Integration

To achieve this target, it would require at least the following steps:

  • Closer banking union – more mergers
  • Unified capital market
  • Universal deposit protection scheme that is pan-european
  • Integration towards a common tax system

Her speech closely echoes that of her fellow countryman – President Macron. However, whilst receiving support from Mrs. Merkel when making his remarks, he also met with objections from other member states. Countries such as the Netherlands and Sweden voiced their objection to what they perceived as “far reaching” policies, whilst ignoring the fundamental problems and issues within the Eurozone. Their concerns are centred around the public perception of the Eurozone – there has been a growing tide of populist sentiment expressed at recent general elections, together with the continued fallout from the financial and sovereign debt crises that has impacted on the economic well being of the citizens.

Implementation of this policy – according to the IMF – would entail an annual contribution of about 0.30-0.35% of GDP per member state into a common fund. This fund would then pay out in the event of an economic downturn. Given the aforementioned level of disenchantment among citizens, it would not be easy to implement this policy within every member state. Furthermore, whilst pay outs would be conditional on member states meeting certain criteria, the Eurozone has shown in the past that their criteria has been ignored and no sanctions were enforced.

This common fund, whilst being ring fenced, could have an impact on the functioning of financial markets. Just knowing that there is a fund that needs to earn a return could led to distortions in money markets. Also, who decides when a member state can draw down from the fund – the EU, the ECB, majority decision of member states?

And then there is the potential problem of moral hazard. A country could pursue policies that are imprudent, safe in the knowledge that there was a communal fund to save them. Given the record of certain member states since even before the inception of the Euro to deceive, this is not a matter to be taken lightly. Even when countries have be found to have cheated they have always received the help that they need, regardless of all the stated criteria that are in place. Countries that are performing well will have to pay proportionally more into the fund than countries whose economies are not doing so well.

10 years since the start of the crisis and almost 20 years since the introduction of the Euro, we are no closer to a collective harmony than before.

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Peer to peer lending – just a fad or a change in the market?

| 27-03-2018 | treasuryXL |

 

Almost 2 years ago we reported that KNAB Bank had started a crowdfunding initiative to allow, mainly companies, to access an alternative area to fund their businesses, whilst at the same time allowing investors to directly participate in these loans and lend directly – via KNAB – to the borrowers. An extra incentive was that KNAB would directly participate in all loans – their role was not only as an intermediary and facilitator. Now is a good time to look back on their progress and refresh ourselves with the concept of peer to peer lending (P2P).

What is it?

It is an online service that matches the needs of the borrowers with that of the lenders. As the service is only related to lending and does not encompass traditional banking roles, the service providers are able to provide these services cheaper and more quickly than a traditional bank loan. The P2P service provider takes a fee – a margin on the interest rate and/or an annual service charge. In recompense, they enable the matching service to take place, administer the loan and ensure that the investors receive their money back – in the form of capital repayments and interest.

What are the features of the system?

  • It is an online facility
  • Intermediation is provided by the site owner
  • Borrowers can post their proposals online
  • Lenders can choose which borrowers and loans meet their criteria
  • Repayment schedule is included
  • Loans can be secured on unsecured
  • Credit ratings are applied to the borrower
  • Loans can be tracked and monitored for compliance

What role does the intermediary play?

  • Process the loan applications
  • Authenticate the validity of the borrower
  • Perform relevant credit checks
  • Process the cash flows
  • Service the loans
  • Ensuring correct compliance and reporting are carried out

What are the advantages?

As the service is an online matching service, it is fast, simple and cost efficient, This leads to lower interest costs for the borrower and allows investors to directly access the loan market and earn a higher return on their money than traditionally obtained at the bank. Also, the administrative processing time can be a lot quicker than by a bank. The system also can appeal to the ethics of a lender – they have the opportunity to directly help a company that is looking to expand or who require finance for major investment. Furthermore, an investor knows exactly who is borrowing their money – depositing money at a bank does not detail how that money is used by the bank. There has been a political and ethical backlash to banks over the last decade in response to the perceived domination they have within the market. As a lender, it is possible to get yields of between 5% and 9% on your investment. This will be lowered by the costs that the intermediary levy – KNAB take a service charge of 0.85% per annum on the outstanding balance.

What are the disadvantages?

As a lender your money is not guaranteed. You bear all the risks and, in the worst case, could lose your investment. Despite all the due diligence that has taken place before the loan request was placed on the platform, it is still necessary to perform your own checks on the potential borrower – your criteria may be different to that used by the platform. You cannot demand early repayment from the borrower – money that you invest must be money that you can miss for the duration of the loan.

 

How is KNAB doing with their P2P?

  • They have arranged funding for 57 loans totalling EUR 9,125,000
  • The average loan is for EUR 160,087, takes 49 hours to complete and charges an interest rate of 7.83% pa
  • There are 4,533 investors with an average exposure for EUR 905 and a yield of 6.98% pa.
  • All loans are based on linear redemption, have a tenor of between 6 months and 10 years.
  • To date there have been no defaults on principal repayments and there are not payments in arrears.
  • Participation can be from EUR 100 per loan – this allows for diversification.

Conclusion

For investors looking for an alternative investment with a longer duration, P2P can appear interesting. The risks are greater than depositing money at the bank, but the potential rewards far exceed the returns offered by banks. Additionally, for investors looking to approach the market more ethically, it does give the possibility of directly participating in someone else’s ambitions – knowing that your participation is having an effect on society. There are considerable risks, but these must be weighed up against the potential reward. Any investor needs to work out how much they can afford to lose on their principal investment against the higher return being offered.

Contact us

 

Credit Default Swap: What is it – good or bad?

| 26-03-2018 | Lionel Pavey |

A decade ago it was one of the financial instruments that was identified as causing the financial crisis. It had been one of the most popular financial products before the crisis with the market turnover growing by more than 50 times over a period of 7 years. It started out as a simple financial instrument to aid bond holders in obtaining protection from the risk of default. So what is a Credit Default Swap (CDS) and where did it all go wrong?

The buyer of a CDS pays regular premiums to the seller of the CDS – expressed in basis points. These payments are normally quarterly in arrears and the total value of the payment is dependent on the nominal value of the contract. This nominal value relates to the par value of the underlying bonds – if you hold bonds with a par value of EUR 5 million and wanted to buy protection for the full amount, then the CDS contract would be for EUR 5 million.

The seller of a CDS would receive these regular payments and would only pay out if the bond issuer defaulted. At the time of a credit event (default), the CDS seller would assume ownership of the bonds and pay the CDS buyer their par value. It can be likened to comprehensive insurance that we buy for our cars – we pay an annual premium and the insurance company covers us for the costs of any damage to the vehicle in the event of an accident.

What is a credit event?

The definitions of a credit event are set out in the contract and defined by referencing terms agreed by the International Swaps and Derivatives Association (ISDA). The major credit events, in European contracts, are bankruptcy, failure to pay on its debt obligations, and restructuring.

A contract will contain standard terms and conditions –

  • effective start date
  • scheduled termination date
  • the agreed price
  • payment dates
  • the reference entity (normally a bond issuer)
  • the reference obligation (usually an unsubordinated bond)
  • substitute reference obligations (if the original was repaid earlier than the termination date of the contract)
  • calculation agent

As previously stated, when the CDS market started it was seen as a product to protect bond holders and, in the event of a default, the CDS buyer could deliver the agreed reference obligation and receive its par value. In 2005, the limitations of this system were first recognised; Delphi – a manufacturer of auto parts – defaulted. The par value of their outstanding bonds was USD 2 billion – the sum of CDS contracts was USD 20 billion. As original bonds had to be tendered to validate the contract, a run ensued on the bonds and, whilst defaulting, the bond price went up!

This led to the next phase – cash settlement. Here, in the event of default, the CDS seller paid to the CDS buyer the difference between the par value and the market price – facilitated by an auction process to determine the fair market value.

However, an unintended consequence was the discovery and creation of different trading strategies that had not be envisaged when the CDS was designed. Before the introduction of CDS contracts, if you were bearish on a company you would need to short-sell their bonds. This is a sensitive process as the short position needs to be covered via bond lending to maintain the settlement position. With CDS it now became possible to purchase protection on a specific entity at a relatively cheap price – the CDS premium. It was therefore possible to replicate a physical short position with a derivative position.

It also led to the creation of “synthetic” instruments – synthetic CDS’s and CDO’s (Collateralized Debt Obligations). The sum of actual tradeable financial instruments were limited by their issue – synthetic products allowed banks to create products to meet the demand from clients to gain exposure to entities. It was a this stage that the market truly grew – it was possible to replicate any exposure that the client desired. When the financial crisis hit, all the “over the counter” derivatives compounded the problems. No one knew what the potential exposure of their counterparties was. These counterparties could have easily sold CDS contracts that could have a potential exposure to the par value of the underlying reference entities of bonds, CDO’s etc.

Is there a future?

CDS are useful financial products – most of the trades now take place on exchanges. However, the genie is not yet back in the bottle. There are now lawsuits – initiated by hedge funds – claiming that defaults are now being prearranged (Hovnanian Enterprises Inc.). The main problem is still who holds the potential risk and for how much. The essence of the product is viable and the original demand is still there. But, as with many financial products, as soon as they become commoditised, market turnover far exceeds the actual underlying market.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist