## F.5 Treatment of Credit Default Swaps: Classification by Type and Risk Category

## Source details

**Canonical URL:** [F.5 Treatment of Credit Default Swaps: Classification by Type and Risk Category](https://www.imf.org/-/media/files/data/statistics/bpm6/fitt/f-5-treatment-of-credit-default-swaps.pdf)

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### Background and context
- Current guidance in BPM6 and 2008 SNA classifies derivatives under two broad types: option-type and forward-type.
- BPM6 definitions cited:
  - Option-type: purchaser acquires a right to buy or sell a specified underlying item at a strike price on or before a specified date; purchaser pays a premium (BPM6 paragraph 5.85).
  - Forward-type: an unconditional contract to exchange a specified quantity of an underlying item at an agreed-on contract price on a specified date; forward-type includes swaps in this guidance note (BPM6 paragraph 5.88).
  - Contrast between types (BPM6 paragraph 5.86): (a) up-front payment usually non-zero for options, usually zero for forwards at inception; (b) during life of contract, forward counterparties can be creditor or debtor and may change, whereas option buyer is always creditor and writer always debtor; (c) at maturity redemption is unconditional for forwards, determined by buyer for options.
- BPM6 paragraph 5.93 identifies credit derivatives as trading credit risk and explicitly notes that credit derivatives take the form of both forward-type (total return swaps) and option-type contracts (credit default swaps).
- Recent market metrics: BIS measure of gross market value of OTC CDS suggests amounts outstanding close to $0.2 trillion.

### Characteristics and functional analysis of CDS
- CDS basics:
  - Contracts between two parties enabling investors to buy protection against the risk of a credit event on a specified reference entity.
  - Functionally similar to an insurance contract: buyer receives payment after a defined credit event to compensate against loss; buyer pays a series of fees (premiums) to seller.
  - Naked CDS: buyer need not have a direct claim on the reference entity.
- Payments and valuation mechanics:
  - Periodic premium paid by protection buyer is called a CDS spread.
  - Standard credit spreads have been established; discrepancies between standard spread and required spread are accounted for by an upfront premium (either paid by buyer or seller).
  - Market value of a CDS changes over lifetime as credit quality of reference entity changes:
    - If credit quality decreases, buyer gains and seller loses (value to buyer increases).
    - If credit quality increases, seller gains and buyer loses.
- Position nomenclature:
  - Protection buyer = short; protection seller = long.
  - Protection buyer benefits when credit quality deteriorates and CDS spread increases; protection seller benefits when credit quality improves and spread declines.

### Comparative characteristics (Table summary)
- Table 1 characteristics preserved as stated:
  - Up-front fee/premium: Forward-type = No; Option-type = Yes; CDS = Yes
  - Regular fees/premiums: Forward-type = No; Option-type = No; CDS = Yes
  - Potential to switch from asset to liability and vice versa: Forward-type = Yes; Option-type = No; CDS = Yes
  - Binding obligation at maturity: Forward-type = Yes; Option-type = No; CDS = No
  - Contingent claim: Forward-type = No; Option-type = Yes; CDS = Yes
  - Margin payments: Forward-type = Yes; Option-type = Yes; CDS = Yes
  - Exchange traded or OTC: Forward-type = Both; Option-type = Both; CDS = OTC
- Key interpretive point: CDS share characteristics with both option-type and forward-type contracts; no single set of characteristics fully aligns CDS with either category.

### Issues for discussion
- Core question: whether CDS should be reclassified from option-type to forward-type given forward-like trait of switching between asset and liability positions.
- Considerations noted:
  - Similarity between CDS and put options from buyer’s perspective (both are contingent unilateral contracts compensating for poor performance of underlying).
  - Impact of any reclassification across other statistical and accounting guidelines.
  - Diversity within forward-type derivatives complicates prescriptive alignment.

### Outcomes considered
- Three possible recommendations evaluated:
  i. continue to classify CDS as option-type;
  ii. reclassify CDS as forward-type;
  iii. recommend supplementary breakdowns of financial derivatives by risk categories where credit derivatives are separately identified.
- Recommended option: i. continue to classify CDS as option-type.
  - Rationale:
    - CDS main features are considered closer to put options: contingent claims and unilateral contracts; protection buyer is compensated when a default (poor performance) occurs, analogous to holder of a put option.
    - Table 1 weighing of characteristics did not demonstrate a sufficiently strong argument to reclassify CDS as forward-type.
    - Majority of FITT members supported maintaining classification of CDS as options during consultation.
- Rejected option: ii. reclassify to forward-type.
  - Rationale for rejection:
    - Although CDS have some forward-like characteristics (asset/liability switching), the co-authoring team does not find a strong enough argument to change classification at this time.
    - Recommendation may be revisited in light of outcomes from topic F.4 – Financial derivatives by type.

### Additional recommendations and analytical enhancements
- Include in next international standards:
  - A brief explanatory text (or text box) highlighting main characteristics of CDS akin to paragraphs 7–10 of the guidance note.
  - Guidance on the valuation of CDS contracts within both the balance of payments’ financial account and the international investment position.
- Propose supplementary breakdowns of financial derivatives by risk categories to enhance analytical use; credit derivatives would be separately identified.
  - Proposed risk categories (to accompany existing by-type breakdown of derivatives):
    - By type (Existing): Options; Forward-type contracts
    - By market risk categories (New): Foreign exchange; Single-currency interest rate; Equity; Commodity; Credit; Other
  - CDS could be identified as an “of which” item within credit derivatives in these supplementary breakdowns.
- Consultation feedback:
  - Majority supported maintaining CDS classification as options and supported the proposed supplementary breakdowns.
  - A few respondents noted greater similarity with forward-type contracts, reinforcing usefulness of separately identifying credit derivatives.

### Questions forwarded for discussion
- Do members agree with the proposal to maintain the classification of CDS as options?
- Do members agree with the proposal to introduce the supplementary breakdown of financial derivatives by risk categories (proposal to be forwarded to F.4 team)?

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_Source: https://www.imf.org/-/media/files/data/statistics/bpm6/fitt/f-5-treatment-of-credit-default-swaps.pdf_