Credit Default swaps(CDS) are a type of financial arrangement between two parties where the seller of the CDS agrees to reimburse the buyer in an event of debt default. Essentially the buyer of the CDS insures the buyer in an event of asset default.
The arrangements involved in a CDS can be explained using an illustration. Let’s assume a bank lent its money to thousands of borrowers as a loan. The bank is worried that in an event of a recession, many of its borrowers may default and it has to bear the risk. So it buys a Credit Default Swap agreement from an insurance firm and agrees to pay a part of the interest from borrowers to the insurance firm. The CDS seller(insurance firm) has to reimburse the bank with principal and interest rate money if any of its borrowers default. In this way, the bank has effectively swapped its financial risk to the insurance company by paying a specific interest rate periodically. The same analogy can be applied to CDS involving bonds, mortgage-backed securities, and debt between two parties.
The main use of CDS is that it can be used as a hedge or as an insurance policy against a default of a bond or a loan. A company vulnerable to credit risk can shift some of its risks by buying protection in a CDS contract. In an event of default, the CDS seller has to deliver the principal and interest payments of the bond or loan.
Credit Default Swaps were introduced to the market in 1997 and gained popularity in the early 2000s. By the end of 2007 over 62 trillion dollars were trapped as CDS deposits and paved the way to the 2008 Financial Crisis. CDSs are not traded on public exchanges and it is not required to report their transactions to a government agency.
CDS contracts are regularly traded where the value of the contract fluctuates with increasing or decreasing probabilities of credit default. If a CDS contract is liable to default, its demand in the market reduces and if credit of a CDS contract is strong, it is traded in high value.
The market for CDS contracts is extremely opaque and is unregulated. The contracts are traded with very high frequency that it is hard to know who stands on the other end of the transaction. There is the possibility that the risk buyer may not have the financial strength to abide by the contract’s provisions, making it difficult to value the contracts. Massive defaults may happen in an event of a market downturn exerting excessive pressure on CDS sellers and aggravate the situation of the market crisis.
As of 2018, CDS contracts value over 3.68 trillion dollars and stand as the most valuable Credit Derivative. Despite the negative perception of CDSs after the 2008 Financial Crisis, it proves to be a great tool for portfolio management and speculation and will remain an integral part of global markets.