Are Credit Default Swaps used by B2B Service providers or Vendors?

Question

I understand CDS's are often employed in trading strategies between institutions - That is well publicized. What isn't as publicized is how other customers might look to use a CDS.

I work in an industry where it is rare to ask for collateral or prepayment (mid-size services vendor) - and where asking for those special provisions could easily cause loss of a customer due to the extra paperwork. On to the questions

• Do services companies (or vendors of other types which I may be less informed about) ever seek out and purchase CDSs as a form of protection from a customer default that they can get unilaterally?
• If this does not occur, is this because the market is inaccessible to such entrants or because the users are ignorant/wary of the market?

Answer 1

Maybe some do but I believe it’s rare because it’s not practical: CDS are traded for a limited amount of companies and CDS might not protect against late or non payment. What is more commonly done is that vendors buy trade credit insurance from insurance companies such as Euler Hermes, Coface or Atradius.

Disclosure: I work for Atradius.

Answer 2

A CDS would not be a good instrument to hedge this kind of credit risk for the following reasons:

1 CDS is traded by two counterparites that have an ISDA agreement. Most participants in this space don't.

2 CDS are traded on a relatively small number of most liquid corporate reference entities. If you want to trade a CDS on an illiquid name, it would be very find someone to trade with, and the bid-offer spread would be huge.

3 CDS typically has a fixed notional, like USD 10 million. But the amount you are owed might be changing day to day. There used to be a version of CDS called "CCDS", where the protection amount was not fixed, but could be linked, for example, to the amount owed at the time of credit event, but it dried up after 2008.

4 The reference obligation is usually a bond. What if the obligor does not default on its bonds, but defaults on your trade claims? You'd have a problem proving that the credit event triggered your CDS.

5 After the default, the "recovery" of the CDS is linked to bonds. You won't be able to deliver your defaulted trade claims - you'll have to deliver defaulted bonds or the cash determined by an auction on bonds.

Historically, CDS was invented as a version of Letters of Credit. You should look at other instruments that are based on Letters of Credit that would work better.