Credit Default Swaps (CDS) and Reporting Under EMIR

History of CDS

Credit Default Swaps were created in the early 1990s as a tool to hedge against credit risk. They became popular among the large banks and were soon able to be traded as securities from JP Morgan, which led to a sharp increase in their popularity. Banks identified this as an opportunity to free up additional capital, and a secondary market of speculative investors generated exponential growth.

Definition and mechanics of a CDS

A Credit Default Swap is a financial swap agreement where the buyer of the swap makes regular payments (the spread) to the seller to transfer the credit risk of securitised debt. The following key terms explain the mechanics of a CDS:

Reference Entity – The issuer of the debt, usually a corporation, government, or other legal entity 

Credit Event – A predetermined event that triggers the CDS contract, such as bankruptcy, failure to pay, or debt restructuring 

Notional Amount – Refers to the face value or par value of the underlying assets in the CDS

Premium Payments – Refers to the periodic payments paid by the buyer to the seller

Cash Settlement – Upon a credit event, the protection seller pays the buyer the compensation owed as per the cash settlement amount, which is the difference between par value and market value 

Physical Settlement – Upon a credit event, the protection seller pays the par value to the buyer and takes delivery of the debt obligation 

The role of CDS in the financial crisis

The 2008 financial crisis exposed significant weaknesses in the financial markets, most notably in the CDS market. The use of CDS for speculation rather than risk mitigation created substantial systemic risk, leading to one of the largest issuers, AIG, requiring a government bailout due to excessive exposure.

The financial crisis highlighted a lack of transparency in financial markets and an increased level of counterparty risk. This sparked substantial regulatory reforms over the next decade, including enhanced reporting requirements under the European Market Infrastructure Regulation (EMIR).

Reporting Credit Default Swaps Under EMIR

ESMA submitted a draft regulatory technical standard (RTS), in line with EMIR to the European Commission on October 2, 2015. This RTS outlines central clearing requirements for specific types of Credit Default Swaps (CDS). 

Table 1 of the RTS proposes mandatory clearing for:

• • • Untranched iTraxx Index CDS (Europe Main, 5 year tenor, series 17 onwards with EUR as the settlement currency)
    • Untranched iTraxx Index CDS (Europe Crossover, 5 year tenor, series 17 onwards with EUR as the settlement currency)

The Delegated Regulation identifies four categories of counterparty:

Category 1: Clearing members in the classes subject to the clearing obligation

Category 2: Financial counterparties above the EUR 8bn threshold or Alternative Investment Funds (AIFs) considered non-financial counterparties and above the threshold 

Category 3: Financial counterparties below the EUR 8bn threshold or AIFs considered non-financial counterparties and below the threshold 

Category 4: Non-financial counterparties not included in Categories 1, 2 or 3 

The Delegated Regulation also brought in frontloading requirements based on the minimum remaining maturity of the contracts entered into prior to the clearing obligation. Special provisions apply to intra-group transactions including phase-in periods which depend on an equivalence decision for the relevant third party. 

Compliance Considerations for Credit Default Swaps

The main obligations and clearing requirements for CDS under UK EMIR differ slightly from the regulations of EU EMIR. The main differences are as follows:

• • • Mandatory clearing – all OTC derivative contracts entered into or novated after the clearing obligation start date, must be cleared through a UK-authorised or recognised CCP. 
    • UK EMIR Refit Updates – introduced a more proportionate clearing regime with key changes such as the introduction of a new category for small financial counterparties (SFCs), and non-financial counterparties (NFCs) are now only required to clear derivatives in the asset classes where they exceed the thresholds
    • Removal of the frontloading requirement – new clearing obligations do not apply retroactively to pre-existing transactions  

CDS can present unique challenges with lifecycle reporting due to the bilateral nature of the agreement. Firms are responsible for meeting these key obligations under the relevant reporting regime and even when delegating responsibility for reporting, are still legally responsible for compliance. 

Adopting effective internal controls and staying up to date with regulatory changes is essential for compliance. 

To streamline these processes and ensure adherence, Novatus Global offer robust software solutions that help you manage clearing obligations with ease. 

Novatus En:ACT is the market-leading SaaS platform, built in conjunction with a major global banking group, to ensure you meet your G20 regulatory reporting obligations in an accurate, timely and complete manner. Talk with one of our experts today.