Credit Derivatives Anatomy™
In the primordial times of Credit Derivatives — the Children of the Woods, the First Men and so on — wise people from JP Morgan and ISDA’s crack drafting squad™ worried that a credit derivative might be able to be characterised as an insurance contract. Bad for many reasons, not least of which that offering insurance is regulated business, requiring compliance with capital rules and so on.
The First Men did what prudent pioneers of financial products do, and sought wise counsel. In this case, a Mr Robin Potts QC, who in 1997 opined that a credit derivative should not be characterised as an insurance contract, because as it is generally structured to pay out upon a Credit Event occurring to the Reference Entity whether or not the buyer is exposed to the Reference Entity or otherwise suffers any loss.
Credit default options differ from insurance contracts because their payment obligation does not depend on the Buyer sustaining or even having a risk of loss. The Buyer need not have an “insurable interest”.
This is so even through it could. Mr Potts did recommended, for the avoidance of doubt that counterparties include a clause stating that they do not mean to enter into an insurance contract. I mean you could, obviously, but there is a Hamlet’s mum aspect to that, and there would be nothing to stop a buyer of an actual insurance contract stating it did not mean it to be an insurance contract.
The Potts opinion is not without its critics — see Oskari Juurikkala’s impassioned arguments from 2011 in the Helsinki Law Journal — many of which make the point that, from the Buyer’s perspective an insurance contract and a credit derivative behave in exactly the same way. Why should there be a different regulatory treatment just because the insured does not need to have an insurable interest if, in practice, it has one?
Then again, an outright gamble is exactly the same. I could buy insurance on my house burning down, buy a derivative compensating me for the loss in value if it does, or you could just have a bet with me that it won’t. If the payoff is “total loss of value in the house” the contracts are, for all intents, the same.
These arguments become ever more pointed as the practical application of credit default swaps became clear: they are hedging tools, not speculative instruments; that is how people use them; for the most part the fact that one could use them to speculate does very little to advance the practical fact that in the real world, most people don’t.