Jurisdiction(s):
United Kingdom

Key definition

Derivatives definition

What does Derivatives mean? Derivatives are contracts used to transfer or manage risk, whose value is determined by an underlying asset, interest rate, currency, index, commodity, security or credit event. Common types include futures, options, swaps (interest rate and currency), forwards and credit derivatives (such as credit default swaps), traded on exchanges or over the counter. Legally, derivatives create payment or delivery obligations calculated by reference to the underlying. They are typically documented under an ISDA Master Agreement with a Credit Support Annex for collateral, and depend on close-out netting upon default. Key issues include counterparty capacity and authority, governing law and jurisdiction,...

Lawyers' Guide to Credit Derivatives: Funded and Unfunded Products (CDS, CLNs, CDOs, TRS, CPPI), ISDA 2014 Definitions, Credit Events, Settlement, EMIR Clearing and Smart Contract Developments

Published by a LexisNexis Banking & Finance expert

Practice notes

What is a credit derivative?

A credit derivative is a two-party contract whose value is tied to the Credit risk of a third party, called the 'reference entity'. That reference entity issues 'reference obligations', being its particular underlying liabilities, both direct and indirect (for example, those without guarantees). The key objective of a credit derivative is to ring-fence the reference entity’s credit risk from its other exposures. The reference entity may be a company, a sovereign, a municipality or a comparable organisation, and it need neither participate in, nor even know about, the deal. This preserves Confidentiality for the counterparties to the credit derivative, as the reference entity could be a client of one of them, and that party may prefer the client not to be aware of the credit derivative. In its most basic guise, a credit derivative is traded over the counter, meaning the trade occurs bilaterally between two parties and not via an exchange. No exchange participation is required in such arrangements. This keeps dealings discreet between the two contractual counterparties only. The party that takes on the reference entity’s credit risk is the 'protection seller', while the party that purchases the credit protection is the 'protection buyer'. If...

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Web page updated on 10/06/2026

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