Credit derivative

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

An unfunded credit derivative is one where credit protection is bought and sold between bilateral counterparties without the protection seller having to put up money upfront or at any given time during the life of the deal unless an event of default occurs. Usually these contracts are traded pursuant to an International Swaps and Derivatives Association (ISDA) master agreement. Most credit derivatives of this sort are credit default swaps. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.

This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic collateralized debt obligations (CDOs); credit-linked notes; single-tranche CDOs, to name a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.

Credit market participants, regulators, and courts are increasingly using credit derivative pricing to help inform decisions about loan pricing, risk management, capital requirements, and legal liability.

The market in credit derivatives started from nothing in 1993 after having been pioneered by J.P. Morgan's Peter Hancock. By 1996 there was around $40 billion of outstanding transactions, half of which involved the debt of developing countries.

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