Credit Derivative Products

The most common credit derivative products include credit default swaps, credit-linked notes ("CLNs"), OTC
deposits, and synthetic collateralized debt obligations ("synthetic CDOs"). Credit default swaps
are the most basic EMCD product and involve payment of a premium by one counterparty
(protection buyer) in exchange for a contingent payment by another (protection seller) in the
event of a specified credit event vis-à-vis a reference obligation or entity (typically, but not
exclusively, sovereign bonds or bonds of blue-chip corporates). Credit default swaps are based on standard ISDA contract documentation, frequently involve standardized contract sizes, and,
in the case of the most liquid underlying sovereign credits and a limited number of blue-chip
corporate credits, enjoy an active broker market with dealers quoting two-way pricing for
standard contract sizes
Credit-linked notes and OTC deposits are moderately more complex products that eliminate the
exposure of protection buyers to the counterparty risk of protection sellers and, as on-balancesheet
instruments, allow those investors restricted from engaging in OTC derivative transactions
to obtain similar economic benefits as offered by credit default swaps. CLNs involve upfront
payment by the protection seller of par value for a note, in exchange for a spread paid by the
note issuer reflecting both the default probability of the reference entity and issuer
creditworthiness. If a credit event occurs, the note redeems early and the investor takes
delivery of a defaulted asset of the reference entity from the CLN issuer, with the investor
sustaining a loss based on the reference asset’s loss.
OTC deposits are similar to CLNs, but involve the placement by the protection seller of a
deposit with the protection buyer - rather than upfront payment of note principal - in exchange
for a coupon incorporating the premium for default protection on a reference asset together with
a spread reflecting issuer credit risk. In a credit event, the depositor typically forfeits the deposit
and takes physical delivery of the defaulted underlying reference asset. OTC deposits are not
Euroclearable and are not listed and are thus generally cheaper and easier to effect.
Synthetic CDO's are among the most complex EMCD products. Synthetic CDOs are typically
"structured" transactions in which a special purpose entity ("SPE") is established to sell credit
protection on a range of underlying assets via individual credit default swaps. The SPE in turn
issues several prioritized tranches of notes to investors, with note proceeds typically invested in
collateral consisting of high-quality government paper to meet contingent credit default swap
payments, while noteholders (in order of seniority) receive both cash flows on the underlying
collateral and premiums on the SPV default swaps. Synthetic CDO's provide an attractive way
for banks and other financial institutions to transfer credit risk on pools of loans or other assets
without selling the assets.
Credit derivatives may involve single name reference assets or a basket of names and can be
customized to meet investor needs. Of the major products, sovereign single- name credit
default swaps appear to be the most liquid. Transactions on corporate credits tend to be more
customized and structured, with CLNs, OTC deposits, and structured default swaps most
prominent.