Moody’s warns investors on digital CDS ‘moral hazard’

Although the rating agency believes such digital products – CDS with fixed recovery rates – offer buyers and sellers of credit protection lower costs, more accurate risk provisioning and greater market transparency, there is the potential for dealers to call more ‘soft’ credit events – events that fall within the Isda definitions of default, but outside that of the rating agencies.

“Unlike conventional CDS structures, where economic incentives for declaring credit events may vary on the basis of a number of different conditions, under digital CDS economic incentives for declaring a credit event are identical for all credit events,” said Moody’s. “However, there are several approaches to mitigating this risk and protection sellers are encouraged to consider any potential for moral hazard that may be incorporated into their structures.”

Digital CDS have become popular as recovery rates for cash-settled CDS and synthetic CDOs display greater variability than recovery rates implied by corporate bond recoveries. This caused credit derivatives arrangers to offer a variety of structural features to lessen this variability. One such feature is a fixed recovery rate that is applied to all credit events.

“Fortunately, these risks can be addressed in a variety of ways, during the structuring process," said Deepali Advani, a senior analyst at Moody's.

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