credit derivative
Credit derivative: a contract that lets one party pass the risk of another party's debt default to someone else, for a fee.
In plain English
Every Nigerian who has ever stood as guarantor for a friend's loan already understands the heart of a credit derivative, even if the term sounds like something only a suited fund manager in London would use.
When you agree to cover your friend's loan if he fails to pay, the bank has effectively moved its risk to you, and it probably pays you nothing for taking it on, which is why guarantors often regret their kindness later.
A credit derivative simply formalises that same arrangement between financial institutions, except the party taking on the risk gets paid handsomely for it, and everything is written down in a contract instead of a favour owed.
Consider a bank in Lagos that has lent ₦2 billion to a large manufacturing company. The bank likes the interest it earns, but it worries the company might struggle to repay if the economy tightens. Instead of losing sleep, the bank can pay another firm a regular fee to take on that default risk. If the manufacturer pays as agreed, the other firm simply keeps collecting the fee. If the manufacturer defaults, the other firm compensates the bank.
This is exactly what a credit default swap does, and it is the most common type of credit derivative, so common that many people use both terms as if they mean the same thing.
In the diaspora world, think of an investment company in the United Kingdom holding bonds issued by an emerging market government. Rather than selling the bonds outright when nervous about repayment, the company can buy a credit derivative that pays out if the government defaults, letting it keep earning interest while sleeping easier at night.
A Nigerian bank holds ₦500 million in corporate bonds and pays another institution ₦8 million a year through a credit derivative contract. If the bond issuer defaults, the other institution pays the bank the full ₦500 million loss. If the issuer pays as agreed, the bank simply keeps paying the ₦8 million yearly fee and carries on.
Questions people ask
Is a credit derivative the same as insurance?
It behaves a lot like insurance because one party pays a fee for protection against a loss, but it is traded in financial markets rather than sold by an insurance company, and the rules around who can buy it are looser.
Can an ordinary Nigerian investor buy a credit derivative?
Not directly in most cases. These contracts are mainly used between banks, investment funds and large institutions because they require deep knowledge of the underlying debt and involve significant sums of money.
Why did credit derivatives get such a bad reputation?
During the 2008 financial crisis, many institutions used credit derivatives so heavily and carelessly that when defaults happened, the losses spread far beyond anyone's expectation, which showed the world how risky these contracts can be when used without care.
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