CREDIT DEFAULT SWAPS
Have you ever wondered how Credit Default Swaps actually work..??
Yesterday I did a small piece on Credit Default Swaps titled “Ever wondered what Credit Defaults were..??
Today I would like to explain how Credit Defaults actually work.
Below is a flow diagram of the process.
Let’s say if Corporation A needs to borrow $1 billion but due to it’s Credit Rating it is rated BB.
Pension Fund may be happy to lend Corporation A the $1 billion but unfortunately can only lend to AAA Credit Rates Corporations.
If Pension Fund is still happy to lend Corporation A the $1 billion they could take out an Insurance Policy with for a small fee with an Insurance Company for $1 billion to cover the costs of the loan should Corporation A default on the payments.
The Insurance Company will charge a fee to the Pension Fund of say 1% of the total $1 billion loan made.
Now should the Pension Fund have missed something in the due diligence of Corporation A and mis-interpreted their Credit worthiness and that Corporation A was most likely going to default, a Hedge Fund would be able to take out an Insurance Policy with either the same Insurance Company or a different Insurance Company to bet on a default.
What more often happens though is that the side bet made by the Hedge Fund is for multiple times the original cover.
In the example above the Hedge Fund has taken out a x10 side bet on the original loan and has paid 1% to cover a $10 billion claim in the event of a default.
In all cases the Ratings Agencies will for a small fee set the Credit Worthiness of all parties involved.
Systemic Risk of failure to such an interconnected and complex unregulated environment is highly likely without some form of shared ledger and is why I strongly believe that the future we will see not only CDSs and DERIVATIVES on the BLOCKCHAIN, but all CREDIT, DEBT, TRADE, CURRENCIES, to name but a few.
As mentioned yesterday, in the coming days, weeks, months I will continue to share on STEEMIT how the adoption of BLOCKCHAIN to the complex DERIVATIVES Market is important for the stability of the Global Financial System in the future.
This is the sort of thing STEEMIT was made for. Cutting edge information that is not only up to date but is not available elsewhere..!!
Thanks again for reading and please feel free to share.
Stephen