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A negative basis trade is a credit derivative trade in which the buyer of a debt instrument purchases credit protection in the form of a credit-default swap.
A negative basis trade is a credit derivative trade in which the buyer of a debt instrument purchases credit protection in the form of a credit-default swap. The negative basis trade protection seller universe has been dominated by AAA-rated financial guaranty insurance companies. The purpose of this Learning Curve is to discuss the major negotiating points in documenting negative basis trade with a monoline insurer.
Protection buyers are primarily, if not exclusively, commercial banks seeking regulatory capital relief, favorable accounting treatment, or both. Credit protection is often secondary, given that many negative basis trades reference AAA-rated notes.
Monolines can and do provide financial guaranties without a CDS but when one is required, they have to provide it through a so-called transformer structure, because they are subject to regulatory restrictions on derivatives trading. A transformer--so-named because it transforms what would be an impermissible trade for a monoline into a permitted trade--is a special purpose vehicle set up in a tax-neutral jurisdiction as a bankruptcy-remote entity solely to serve as a negative basis trade counterparty. The sponsoring monoline provides a financial guaranty to the protection buyer and will make payments under the financial guaranty if there is a credit event. These SPVs typically have no assets of their own, so either the monoline will give the money to the SPV in order to pay the protection buyer under the CDS or the monoline will pay the protection buyer directly pursuant to the guaranty.
Major Negotiating Points
Although each counterparty is different, and the issues below do not constitute an exhaustive list, the following issues frequently arise during negative basis trade negotiations.
Credit Issues
a. Settlement
Monolines have traditionally favored a modified version of physical settlement called pay-as-you-go, similar to the International Swaps and Derivatives Association's PAUG settlement, but with one distinctive feature. In all PAUG CDS, the seller's obligation is to make periodic...