What are credit derivatives?

A credit derivative is an over-the-counter bilateral transaction whereby the lender transfers the risk that a loan will not be repaid to another party.

This guidance note details what a credit derivative is and explains the types of funded and unfunded credit derivatives and how they work. It provides the rationale for using a credit derivative and how they are documented. It also considers what a constitutes a default ie a credit event, under a credit derivative and how they are settled.

Finally how credit derivatives are cleared in Europe.

See What are credit derivatives?

An introduction to the 2014 ISDA Credit Derivatives Definitions and Key terms found in the ISDA Credit Derivatives Definitions

When a party is documenting a credit derivative transaction, typically the confirmation will incorporate the 2014 ISDA Credit Derivatives Definitions (the 2014 Definitions).

This guidance note covers what the 2014 Definitions are and why they are used. It explores the key changes made to the 2003 ISDA Credit Derivatives Definitions and why these were deemed necessary.

See An introduction to the 2014 ISDA Credit Derivatives Definitions and Key terms found in the ISDA Credit Derivatives Definitions.

Key terms found in the ISDA credit derivatives definitions

This guidance note sets out what each section of the 2014 ISDA Credit Derivatives Definitions covers.

See Key terms found in the ISDA Credit Derivatives Definitions.

Credit derivatives — credit events

A credit derivative aims to give the purchaser protection against the occurrence of a number of different credit events occurring on the underlying reference entity to that transaction. What a credit event is and the types of credit events that can occur are set out in the 2014 ISDA Credit Derivatives Definitions. They are:

• • Bankruptcy;
• • Obligation Acceleration;
• • Obligation Default
• • Failure to Pay;
• • Repudiation/Moratorium;
• • Restructuring; and
• • Governmental Intervention.

This guidance note describes each of the seven credit events and shows which credit event applies to each transaction type. Additionally, the guidance note considers the two types of obligations that need to be understood when a credit event occurs. They are:

• • Reference obligations; and
• • Deliverable obligations.

ISDA’s 2019 Narrowly Tailored Credit Event Supplement which contains amendments to the 2014 ISDA Credit Derivatives Definitions is discussed.

See Credit derivatives — credit events.

Restructuring credit event

While there are a number of credit events, the Restructuring credit event is the most complex of the credit events. The 2014 ISDA Credit Derivative Definitions have sought to clarify this credit event which has been the source of dispute and uncertainty in the market. This guidance note explains when a restructuring credit event occurs and when it will not occur. It further considers physical settlement options following a restructuring credit event.

See Restructuring credit event.

Triggering and settling credit derivatives

The occurrence of a credit event is not sufficient to trigger performance under a credit derivative — certain formalities must also be complied with. Since 2009, the majority of credit events are determined by the ISDA Credit Derivatives Determinations Committee (the DC). A credit event is triggered by raising a question with the DC or by sending a credit event notice to the other party. This guidance note describes the DC and describes the documentation that should be sent on the occurrence of a credit event.

See Triggering and settling credit derivatives.

Credit derivatives — settlement procedures

Once a credit derivative transaction has been triggered, the parties to that transaction will want to settle it so that each receives any amounts that are owing to it. This guidance note describes each of the settlement method parties may elect which will apply for the relevant transaction:

• • auction settlement;
• • cash settlement; or
• • physical settlement.

This guidance note describes each of the three settlement methods.

See Credit derivatives — settlement procedures.

Total return swaps

Because a total return swap resembles a credit default swap it is characterized as a credit derivative though there are some differences between them. This guidance notes explains where they are similar and where they are different. Further a step by step guide as to how total return swaps work is set out in this guidance note.

See Total return swaps.