What are credit default swaps?

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Credit default swaps (CDS) are a type of financial derivative that provides insurance against the risk of default on a debt obligation. They are a contract between two parties, in which one party agrees to pay the other in the event of a borrower’s default on a loan or other debt obligation.

Here’s how credit default swaps work, their role in the Great Recession and answers to frequently asked questions about CDS.

What are credit default swaps and how do they work?

Credit default swaps insure a loan or bond in case of default. They allow the CDS buyer to transfer the credit risk of the underlying asset to another party. Buyers make periodic payments to the seller, typically quarterly or monthly until the contract’s maturity (end) date or until a credit event is triggered. In a way, a CDS operates like an insurance policy.

The seller of the CDS pays the buyer if there is a credit event in the underlying asset, such as a bankruptcy. Credit default swaps are widely used for hedging risk and speculation. For example, if a bank has a large real estate loan, it can buy a CDS to protect against the risk of default losses. Investors can also use CDS to speculate on the creditworthiness of a company or country.

Although CDS are usually traded over the counter (OTC), they are not as regulated as exchange-traded products. Before the 2007-2008 financial crisis, they were even less regulated.

How do credit default swaps trigger?

In a CDS contract, typically the buyer and seller agree upon a number of credit events that would initiate the CDS buyer settling the contract. Settling the contract generally means the sellers will receive cash or a bond from the buyer.

Credit events can range from failure to pay to obligation restructuring, which is when the underlying loans are restructured, to bankruptcy. A full list of credit events should be listed in the contract.

Is trading in credit default swaps legal?

Yes, it’s legal. CDS fall under the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) regulations which cover the parties involved and their activities. The passing of the Dodd-Frank Act in 2010 introduced stricter regulations on CDS and imposed stringent record-keeping and reporting requirements on buyers and sellers to help prevent adverse effects on the market.

However, some argue that “engineered” credit default swaps, which is when an investor collaborates with financially distressed borrowers to guarantee the profitability of their CDS position, should be more regulated. Currently, they fall under a legal gray area. According to a New York University Law Review paper from 2019, engineered CDS can “inflict negative externalities upon third parties, including diminishing pricing efficiency, impairing market integrity, and imposing costs on non-CDS investors.”

The role of CDS in the 2008 financial crisis

Prior to the credit crisis, credit default swaps were very popular, with an outstanding value in excess of $45 trillion. Investment banks created mortgage-backed securities, credit default swaps and collateralized debt obligations (CDOs), and placed bets on the performance of these derivatives. The insolvency of banks trading in CDS caused significant fluctuations, and bond insurance companies had to raise capital in the event of possible defaults. According to a Time report from 2008, it was common for a CDS to be traded 15 or more times which resulted in confusion if a default occurred. The party responsible for curing the default (paying the money required by the contract) was hard to even determine and whether they could cure the default was another matter entirely.

The Dodd-Frank Act now gives regulatory authority over the swaps market for securities to the SEC and CFTC. The act requires parties to record and report all CDS transactions.

Bottom line

Credit default swaps are designed to provide protection against fixed-income products. They are legally traded in the U.S. and regulated by the SEC and CFTC. Although they can offer investors protection against default, they also come with high levels of risk and should be used with caution.