Potts opinion

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In the primordial times of Credit Derivatives — the Children of the Forest, 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 occuring to the Reference Entity whether or not the buyer is exposed to the Reference Entity or otherwise suffers any loss.

At common law an insurance policy is “a contract to indemnify the insured in respect of some interest which he has against the perils which he contemplates it will be liable to.”

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 — in that but for this artificial distinction, the contracts can fulfil exactly the same role. 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.

See also

• Credit Derivatives Anatomy
• Equity v credit derivatives showdown