An Explainer By DelphX On Bringing The Credit Default Swap Into The 21st Century

An age-old concern in banking revolves around the risk of non-repayment.

Banks would have billions, at times, in loans to entities — everything from governments to businesses — and, given regulatory frameworks, they would be obliged to hold collateral in case of default.

In 1994, Blythe Masters of JPMorgan Chase & Co’s JPM swaps team, pitched the idea of selling credit risk in return for fees. This meant that the bank would offload the risk of repayment in exchange for a fee. The entity that would then warehouse this risk would receive regular payments, freeing up capital for the bank, as a result.

The scheme was named the credit default swap, or CDS.

In light of the CDS market’s stabilization and growth, after the 2008 Financial Crisis, Benzinga spoke with DelphX Capital Markets’ DPXCF Patrick Wood on his firm’s intent to move the market into a new age.

Benzinga: Patrick, it is nice to meet you. Can you tell me more about your background?

Wood: I’m a plus-25-year capital markets veteran. I’ve worn many hats over my career starting as a stockbroker. I traded fixed income at a certain point and was in institutional sales.

About 10 or 11 years ago, I started a company called Tormont Group, an investment banking advisory based in Los Angeles, Toronto, and Las Vegas, as well.

One of our missions at Tormont was to take high-growth companies in the U.S. public in Canada because of the great small micro-cap market … and the big pool of capital that gets behind those types of high-velocity investments and opportunities, there.

Where does DelphX come in?

DelphX is one of the companies we took public back in 2018.

The company created two new products which had the ultimate goal of bringing liquidity back to the credit markets … obliterated back in 2007 and 2008 … [after] you had three people sitting in an office at dealers like AIG, writing CDS all day long without any coverage because they never anticipated that the mortgage market would implode.

In 2020, I came into the company as CEO. The board felt that there was a need to kind of turn the company around and refresh the vision.

We built a team of advisors on Wall Street — people who, in some cases, have written hundreds of billions of CDS in their careers — who really took apart the product portfolio.

What is DelphX’s offer? What do you do differently from other participants in the market?

If you’ve got an underlying bond — let’s call it an Archer-Daniels-Midland Co ADM bond — and you want to offset the risk of default on that bond, you would invest in something called a CPO, or collateralized put option.

Like a CDS, a CPO protects you in the event of default.

Say you want $100 million of coverage. Essentially, you’re betting on that CUSIP defaulting at some point and you’re going to find somebody on the other side of this trade, the collateralized reference note, or CRN investor.

That CRN investor would say: ‘Okay, I’m willing to accept the risk on that bond in return for a premium or fee to take that risk.’

You’re bringing two buy-side institutional investors together. One is offsetting risk or speculating on it. The other one is guaranteeing the risk and assuming the risk in return for a premium.

The premium — which gets paid directly to the person assuming the risk — goes into a Treasury bond. It’s fully transparent and collateralized. There is zero counterparty risk in this mechanism.

From an environmentally and socially, and certainly from a governance perspective, it’s a new product that fits the bill and takes CDS and, to some extent, credit-linked notes, and brings them into the 21st century.

What’s a better way to tell me what you said without telling me what you just said?

By virtue of being a Rule 144A security, we’re essentially private placement security.

Our business model, as a company, is really to have some conversion from the CDS space, over to what we’re doing, but also bring in that other investor who doesn’t look at CDS and credit-lined notes because they want something transparent, guaranteed, and collateralized.

The value-add for the CRN investor capturing the premium, from the CPO, is that they’re getting paid upfront, but they’re also collecting interest on the collateral.

Based on current CDS pricing, and our pricing models, our CRN investors are earning 30% more for the same pari-passu risk of default, on that underlying bond, as they would by owning the individual bond.

How do you think about product evolution? You’ve got a better product. How do you make it even better?

It’s still an outdated market. You have, usually, a dealer on one side of the phone, talking to a dealer on the other side. Every now and then, they use Bloomberg chat but, really, it’s an archaic way of dealing.

What we’re doing is designing the front-end of this, which will be automated, and that transformation we think will be a huge opportunity for DelphX. We fully expect to be operational by the second half of 2022 with that automated platform. That leads to the next step of our process which is to become an alternative trading system or ATS for structured products.

We create an automated marketplace for the secondary market of CPOs, CRNs, and, potentially, other structured products.

Trends we should be aware of?

There is complacency on the street; there’s no real worry right now, and that’s a bad sign.

A few weeks ago, I saw our models, and a five-year Amazon Inc AMZN bond was yielding 0.88. The five-year Treasury was 0.76.

To see that kind of compression indicates that there’s a lot of complacencies that there will always be the Federal Reserve to backstop anything that goes wrong.

That’s a great opportunity for DelphX and our CPOs to be a risk mitigation tool for when things start to turn the corner.

How do you scale in a market that is so big? How do you get the word across?

So, we already have our broker, but we’re going to launch our own buy-side to buy-side sales initiative. We’re having discussions with strategic partners around that, but we’re also courting investment banking … dealers, and banks as being real sponsors to our product.