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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 –
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
Cash Management and Treasury Specialist
Ripple is making blockchain waves
| 23-03-2018 | Carlo de Meijer |
BROADENING RIPPLE OFFERINGS
Ripple was set up in 2012 to create a streamlined, decentralized global payments system named RippleNet, using technology inspired by the blockchain, to record transactions between banks. RippleNet is an enterprise-grade blockchain platform, that nowadays has over 100-member banks and financial institutions. These partners can use all the Ripple offerings.
Solutions
Ripple makes software products based on blockchain technology and sell them to banks, payment providers and others to be used on RippleNet. These are aimed to make cross border payments truly efficient for these players and their customers. Next to their digital asset XRP, the XRP Ledger, and xCurrent, that helps banks settle transactions, Ripple has added a number of new services/offerings to the platform including xRapid and xVia. This in order to attract more clients to enter RippleNet. Ripple is now taking the next step to help build the Internet of Value (IoV), by establishing an Infrastructure Innovation Initiative.
a. XRP: digital asset
From the outset, XRP, Ripple’s digital asset was expected to be an important part of Ripple’s decentralised payment system. Ripple uses its own XRP cryptocurrency as a payment method to make it easier for banks to move money internationally. Banks and payment providers can use Ripple’s digital asset XRP to further reduce their costs and access new markets. One rationale for using XRP is that unlike Bitcoin, the token has one narrowly defined (payments method!) but clearly useful purpose: to help banks move cash faster and more cheaply, especially across borders. The token could be used as a kind bridge currency between fiat currencies. For example South African rands in Johannesburg could become XRP, which could then be turned into baht in Thailand. That could help banks avoid the time consuming and expense of tying up money in different currencies in accounts at other banks.
b. xCurrent: processing payments
RippleNet is powered by xCurrent, for payment processing. xCurrent is the new name of Ripple’s existing enterprise software solution that enables banks to instantly settle cross-border payments with end-to-end tracking (and bidirectional messaging across RippleNet). It provides real-time messaging, clearing and settlement of financial transactions. The xCurrent messaging platform however does not involve XRP. It includes a Rulebook developed in partnership with the RippleNet Advisory Board to standardise all transactions across the network. That ensures operational consistency and legal clarity for every transaction. The Interledger Protocol (ILP) is the backbone of the solution and makes it possible for instant payments to be sent across a variety of different networks.
Read the full article of our expert Carlo de Meijer on LinkedIn
Carlo de Meijer
Economist and researcher
Unilever’s decision – the Ides of March?
| 22-03-2018 | treasuryXL |
Framework
Whilst having a dual listing, 55% of the stock are held via the Dutch NV and 45% by the UK PLC. Liquidity in share trading is 1.5 times higher in the Netherlands than in the UK. After this decision, Unilever will have 3 divisions – food and refreshment based in the Netherlands, home care and personal care which are both based in the UK. Under this split, 49% of operating profit is attributed to operations in the Netherlands, the remaining 51% to the UK. Importantly, 92% of the activities occur worldwide outside of these 2 countries.
Nationality
Unilever has one major issue that must be resolved – it must choose its nationality. This is important in determining on what exchanges its shares are traded. As a major constituent of both the AEX and the FTSE, there are many investors and investment funds who hold shares to track the index. If there is no recognised nationality with the UK, this would imply Unilever leaving the FTSE 100 – compelling tracker funds to sell their stock. By incorporating within the Netherlands, Unilever will have one type of share – common shares with common voting rights. There will be no preference shares with extra voting rights.
Brexit
Was the decision taken because of Brexit? Unilever themselves have stated that this was not the case. It is acceptable to conclude that the free choice of the UK to leave the EU did not promote the option to stay in the UK. However, Relx (former Reed Elsevier and also a dual listed Anglo-Dutch company) recently announced that they had also chosen a single location – but they chose UK over the Netherlands.
Defensive
In 2017 Kraft Heinz (a US conglomerate) made a hostile takeover bid for Unilever. This was beaten, but accelerated the decision process within Unilever. By choosing a single listing and single nationality it would appear to be easier to defend the company. The Dutch model affords more protection to the takeover target, being based on the Rhineland model of stakeholders, rather than the Anglo-Saxon model based on shareholders.
The future
Unilever will gain clarity of oversight – the structure of the company is clearer. As a single legal entity it will be easier to issues new shares etc. It should also place Unilever in a more progressive position with regards to acquisitions. This could be interesting news for Dutch banks – allowing them to more directly participate. However, the City of London is still home to the largest financial market in Europe. It will be interesting to see who wins that battle in the future.
The 15th March is historically known as the Ides of March – a day on the Roman calendar. Traditionally it was the date when debts had to be settled. It was also the date when the emperor, Julius Caesar, was assassinated – a defining day in the history of the Roman Empire, that impacted on its future.