Party Autonomy in International Property Law - Peace Palace Library

D. Assignment; Financial Instruments; Insolvency Law
the amounts paid out under the credit protection sold by the protection
seller. Moreover, credit default swaps enable protection sellers to take on
credit risks against entities without having to invest directly in securities
issued by those entities. In our example, there may be regulatory reasons
that make it difficult for Rock Solid Bank to purchase debt instruments
issued by Issuer directly, but by selling credit protection it has assumed
the risk without needing to purchase debt instruments. This is also one of
the reasons why selling credit protection may be quite dangerous; without
credit default swaps, taking on the credit risk of EUR 20,000,000
against Issuer in our example would require an initial investment of EUR
20,000,000. If the risk is taken on through a credit default swap, no such
initial investment by the protection seller is required. Consequently,
credit default swaps increase leverage. 5
Moreover, as was shown during the credit crisis, they increase the overall
strains on the financial system because total losses of all market participants
may well increase due to a single issuer of debt defaulting on its
obligations. There is no need to actually have a credit exposure against
the reference entity (Issuer) to purchase credit protection. Many parties
may have bought (and sold credit) protection and consequently, a single
default by Issuer may give rise to a great number of payment obligations
that in aggregate may be many times larger than the total amount of debt
issued by Issuer.
The above shows that a credit default swap in its most basic form could
be seen as an insurance against a credit risk. It provides protection against
non-performance of a debtor usually by a third party (the protection
seller) undertaking to pay an amount to the creditor if its debtor does
not perform its obligations. 6 From a legal perspective, however, credit
default swaps are not (and should not be) qualified as insurance contracts.
Qualification as an insurance contract would lead to regulatory issues
which might lead to the contracts being void because insurance may only
be provided by licensed insurance undertakings. The key point here as a
matter of English law is that under a credit default swap, payments must be
5
See EC Commission Communication, ‘Ensuring efficient, safe and sound
derivatives markets: Future policy actions’, 20 October 2009, COM(2009)
563 / 4, available at ec.europa.eu / ​internal_market / ​financial-markets / ​docs / ​
derivatives / 20091020_563_en.pdf.
6
See Hudson 2009, § 43-42 et seq.; and Eric Dickinson, ‘Credit Default Swaps:
So Dear To Us, So Dangerous’, available at ssrn.com / ​abstract=1315535.
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Reinout M. Wibier
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