A credit default swap (CDS) with a fixed recovery rate that is determined at inception and applied to all credit events is sometimes referred to as a "digital" or "binary" credit default swap. These structures offer both protection-buyers and -sellers several benefits. The valuation process, which is otherwise central to the cash settlement process, is avoided altogether, removing the need to ensure that its provisions are objective and comprehensive. Most importantly, the variability of recovery rates that is often present with cash settled credit default swaps is no longer present. Additionally, concerns surrounding liquidity of distressed or defaulted asset backed securities (ABS) are also mitigated.

Although digital CDS still represents only a fraction of the CDS market, interest is growing rapidly. Nevertheless, there are risks associated with digital credit default swaps that differ from those associated with more conventional CDS. These risks are more likely to occur when soft credit events are present, and may be addressed in a number of ways.

Background

The concept of a fixed recovery rate can be applied to CDS of either corporate or asset-backed credit risk. These cash-settled structures remove the need for a valuation process altogether. Arrangers are spared both the time and expense associated with valuation procedures. Cash settlement can occur almost immediately after conditions to payment are met. Factors such as minimum time to valuation and market conditions at the time of valuation, that would ordinarily affect recoveries, become moot under these contracts.

In removing the valuation process from cash-settled CDS transactions, many of the usual reporting requirements such as the Valuation Obligation Identification Notice and the Final Valuation Notice are also unnecessary. Finally, the presence of a fixed recovery rate removes the potential for moral hazard that is often associated with the valuation process and all variability of recovery rates that may be realized by CDS and synthetic CDO investors.

However, there are risk factors associated with digital CDS that are not generally associated with more conventional CDS structures. For example, when soft credit events occur, protection-buyers will, on occasion, not declare a credit event, or they will wait to declare a credit event in anticipation of a "hard" credit event and a greater loss because of the time and cost associated with the auction process. Unlike situations where the recovery price of a reference entity may be sufficiently high that declaration of a credit event may not have made economic sense, under a digital default swap, declaration of all credit events make equal economic sense.

While most digital CDS is documented with the standard ISDA 2003 Credit Derivative Definitions that are used for conventional CDS, the motivation to declare credit events is inevitably influenced by the fact that buyers of protection are certain as to the credit loss amount that will be due.

In other words, digital CDS may create an incentive for credit protection-buyers to call soft credit events more frequently. At the same time, they do not allow credit protection- sellers to realize the offsetting benefit of higher recovery rates that tend to accompany soft credit events.

Rating approach to digital CDS

To account for shifting incentives and potential moral hazard, Moody's suggests some form of additional objective criteria to determine that a credit event has occurred. The following are optional provisions that function as objective measures and mitigate moral hazard:

* Quantitative analysis can be adjusted to account for potential risks associated with higher probabilities of soft credit events being called.

* Credit derivative documentation can be tailored to provide an objective view that a credit event has in fact occurred. One method is for the protection-buyer to deliver the Credit Event Notice and a Notice of Publicly Available Information plus an additional piece of information showing that a credit event was called on the reference entity by at least two unaffiliated counterparties on non-digital default swaps. Delivery of this information would be a condition to payment when the credit event that is called is a soft credit event.

* A price test can be used as a fallback measure. Credit protection-buyers would be required to verify the post-credit event price of the valuation obligation. If the price were to be above a certain level (which would indicate a soft credit event), the credit event would become ineligible to be called under the digital CDS.

To properly analyze digital CDS, it is necessary to consider the increased likelihood that soft credit events will be called. Nonetheless, there are several approaches to mitigating this risk. In addition to those described above, Moody's approach to rating digital CDS is sufficiently flexible and transparent to accommodate any number of methods that may be proposed for eliminating the additional risks associated with a fixed recovery rate being applied to CDS.

In general, Moody's views the evolution toward CDS with a fixed recovery rate as a positive market development. Most notably, the uncertainty regarding recoveries on CDS is entirely mitigated. However, there are issues that are particular to these structures that should be considered.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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