Credit Default Swap (CDS)

What is a Credit Default Swap?

A credit default swap (CDS) is a financial derivative that transfers the credit exposure of a debt instrument (for example, bonds, mortgage‑backed securities, or loans) from one party to another. The buyer of protection makes regular premium payments to the seller of protection. If a specified credit event occurs with the reference borrower, the seller compensates the buyer for losses defined by the contract.

How CDSs work

• Parties: protection buyer (seeks insurance against default) and protection seller (accepts risk in exchange for premiums).
• Notional amount: the face value of the debt being protected.
• Premiums: typically paid periodically until contract maturity or until a credit event triggers settlement.
• Settlement: when a credit event happens, the contract is settled either by delivering the underlying bonds (physical settlement) or by paying a cash amount equal to the loss (cash settlement).

Credit events

A CDS specifies which credit events trigger payment. Common triggers include:
– Failure to pay: missed scheduled payments.
– Bankruptcy or default for reasons other than missed payments.
– Obligation acceleration: debt becomes immediately due.
– Restructuring: repayment terms are changed.
– Repudiation or moratorium: contractual obligations are disputed or temporarily suspended.
– Government intervention that materially alters payment terms.

Terms and settlement details

• Term length can be tailored (e.g., to cover only a part of a bond’s remaining life).
• Physical settlement involves the buyer delivering the reference bonds to the seller in exchange for par.
• Cash settlement uses an auction or market process to determine the post‑default market value of the reference obligation; the seller pays the shortfall.
• Cash settlement is common where underlying bond liquidity is limited or when CDSs are traded primarily for speculation.

When and why CDSs are used

• Hedging: lenders, pension funds, insurers, and other holders of fixed‑income assets buy CDS protection to reduce exposure to a borrower’s default risk.
• Speculation: traders buy or sell CDSs to profit from changes in perceived credit risk or from spreads between markets.
• Arbitrage: investors exploit pricing differences between the bond and CDS markets (for example, buying a bond while buying protection via CDS).

Market scale

CDSs are the dominant type of credit derivative and represent a significant portion of the credit‑derivatives market globally, with the notional amount measured in the trillions of dollars.

Historical note: role in the financial crisis

CDSs were heavily used around mortgage‑backed securities and collateralized debt obligations prior to the 2007–2008 crisis. Widespread use, interconnections among financial institutions, and concentrated exposures contributed to systemic stress when the underlying mortgages defaulted and housing prices collapsed.

Advantages

• Risk transfer: allows lenders and investors to reduce exposure to specific credit risk.
• Flexibility: contracts can be customized for term and reference obligation.
• Access and diversification: exposure to credit risk without owning the underlying security.
• Liquidity and trading opportunities: CDS markets enable quick position adjustments and speculative strategies.

Disadvantages and risks

• Counterparty risk: the protection buyer is exposed to the seller’s ability to pay if a credit event occurs.
• Complexity and opacity: terms can be intricate and less transparent than exchange‑traded products.
• Overreliance / moral hazard: buyers may be lulled into excessive risk taking if they assume protection is absolute.
• Market illiquidity: liquidity can evaporate during stress, making it difficult to unwind positions.
• OTC trading: historically many CDSs were traded over the counter, increasing settlement and reporting complexity (though reforms have increased central clearing).

Managing counterparty risk

• Due diligence: assess counterparties’ creditworthiness before entering contracts.
• Diversification: spread exposures across multiple counterparties.
• Collateral agreements: use margining and credit support annexes to require collateral posting.
• Central clearing: use clearinghouses where available to reduce bilateral counterparty exposure.

Common questions

What triggers payment under a CDS?
– A qualifying credit event, as defined in the contract (e.g., failure to pay, bankruptcy, restructuring), triggers settlement.

Are CDSs legal and regulated?
– CDSs are legal. After the financial crisis, reforms increased regulatory oversight, reporting requirements, and central clearing for many standardized CDS contracts.

What are the primary uses of CDSs?
– Hedging credit risk, speculative trading on credit quality, and arbitrage between credit markets.

Conclusion

Credit default swaps are powerful tools for transferring and trading credit risk. When used prudently, they provide effective hedging and price discovery for credit markets. However, they carry counterparty, complexity, and liquidity risks that require careful risk management and, where possible, the use of standardized contracts and central clearing.