What Is a Credit Default Swap (CDS)?
A credit default swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.
Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy. A lender who is worried about a borrower defaulting on a loan often uses a CDS to offset or swap that risk.
Key Takeaways
- A credit default swap (CDS) is a type of derivative that transfers the credit exposure of fixed income products.
- In a credit default swap contract, the buyer pays an ongoing premium similar to the payments on an insurance policy. In exchange, the seller agrees to pay the security's value and interest payments if a default occurs.
- In 2023, the estimated size of the U.S. CDS market was over $4.3 trillion.
- Credit default swaps can be used for speculation, hedging, or as a form of arbitrage.
- Credit default swaps played a role in both the 2008 Great Recession and the 2010 European Sovereign Debt Crisis.
How Credit Default Swaps (CDSs) Work
A credit default swap is a derivative contract that transfers thecredit exposureoffixed incomeproducts. It may involve bonds or forms of securitized debt—derivatives of loans sold to investors.
For example, suppose a company sells a bond with a $100 face value and a 10-yearmaturityto an investor. The company might agree to pay back the $100 at the end of the 10-year period with regular interest payments throughout the bond's life.
Because the debt issuer cannot guarantee that it will be able to repay the premium, theinvestorassumes the risk. The debt buyer can purchase a CDS to transfer the risk to another investor, who agrees to pay them in the event the debt issuer defaults on its obligation.
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Debt securitiesoften have longer terms to maturity, making it harder for investors to estimate the investment risk. For instance, a mortgage can have terms of 30 years. There is no way to tell whether the borrower will be able to continue making payments that long.
That's why these contracts are a popular way to manage risk. The CDS buyer pays theCDS selleruntil thecontract's maturity date. In return, the CDS seller agrees that it will pay the CDS buyer the security'svalueas well as allinterestpayments that would have been paid between that time and thematurity date if there is a credit event.
Credit Events
The credit event is a trigger that causes the CDS buyer to settle the contract. Credit events are agreed upon whenthe CDS is purchased and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers:
- Reference entity default other than failure to pay: An event where the issuing entity defaults for a reason that is not a failure to pay
- Failure to pay: The reference entity fails to make payments
- Obligation acceleration: When contract obligations are moved, such as when the issuer needs to pay debts earlier than anticipated
- Repudiation: A dispute in the contract validity
- Moratorium: A suspension of the contract until the issues that led to the suspension are resolved
- Obligation restructuring: When the underlying loans are restructured
- Government intervention: Actions taken by the government that affect the contract
Size of the Credit Derivatives Market
Terms of a CDS
When purchased to provide insurance on an investment, CDSs do not necessarily need to cover the investment for its lifetime. For example, imagine an investor is two years into a 10-year security and thinks that the issuer is in credit trouble. The bond owner may buy a credit default swap with a five-year term that would protect the investment until the seventh year, when the bondholder believes the risks will fade.
Settlement
When a credit event occurs, the contract may be settled physically, historically the most common method, or by cash. In a physical settlement, sellers receive an actual bond from the buyer. Cash settlement, though, became the more preferred method when the purpose of CDSs shifted from hedging tools to speculation. In this type of settlement, the seller is responsible for paying the buyer for losses.
The U.S. Comptroller of the Currency issues a quarterly report on credit derivatives. In a report regarding the first quarter of 2023, it placed the size of the entire credit derivative market at $5 trillion, over $4.3 trillion of which were CDSs.
When Are CDSs Used?
As aninsurancepolicy against a credit event on an underlying asset, credit default swaps are used in several ways.
Speculation
Because swaps are traded, they naturally have fluctuating market values that a CDS trader can profit from. Investors buy and sell CDSs from each other, attempting to profit from the difference in prices.
Hedging
A credit default swap by itself is a form of hedging. A bank might purchase a CDS to hedge against the risk of the borrower defaulting. Insurance companies, pension funds, and other securities holders can purchase CDSs to hedge credit risk.
Arbitrage
Arbitrage generally involves purchasing a security in one market and selling it in another. CDSs can be used in arbitrage—an investor can purchase a bond in one market, then buy a CDS on the same reference entity on the CDS market.
A credit default swap is the most common form ofcredit derivativeand may involvemunicipal bonds, emerging market bonds,mortgage-backed securities (MBS),orcorporate bonds.
The Great Recession
CDSs played a key role in the credit crisis that eventually led to the Great Recession. Credit default swaps were issued by American International Group (AIG), Bear Sterns, and Lehman Brothers to investors to protect against losses if the mortgages that were securitized into mortgage-backed securities (MBS) defaulted.
Mortgage-backed securities are mortgages bundled into packages and then offered as shares. The CDSs were insurance against mortgage defaults, so investors believed that they had completely reduced the risk of loss if the worst were to happen.
Mortgages were given to nearly anyone that requested them because investment banks and real estate investors were generating huge returns as housing prices continued to climb. CDSs allowed investment banks to create synthetic collateralized debt obligation instruments, which were bets on securitized mortgage prices.
Because these investment banks were so entwined in global markets, their insolvency caused global markets to waver and ushered in the financial crisis of 2007-2008.
Many investment banks issued MBSs, CDSs, and CDOs: they were all betting on the performance of their own mortgage security derivatives. When housing prices collapsed, the big players could not pay all of their obligations because they owed each other and investors more money than they had.
European Sovereign Debt Crisis
Credit default swaps were widely used during the European sovereign debt crisis. For example, investors purchased Greece's sovereign debt through sovereign bonds to help the country raise money. They also purchased CDSs to protect their capital in case the country defaulted.
Portugal, Ireland, Italy, Cyprus, and Spain all nearly collapsed financially during this time.
Advantages and Disadvantages of CDSs
Advantages Explained
- Reduces risk to lenders: CDSs can be purchased by the lender, which acts as a form of insurance designed to protect the lender and pass the risk on to the issuer.
- No underlying asset exposure: You're not required to purchase underlying fixed-income assets.
- Sellers can spread risk: CDSs pass the risk of defaulting on payments to the issuer. They can also sell multiple swaps to spread risk further.
Disadvantages Explained
- Can give lenders and investors a false sense of security: Investment insurance makes investors feel they don't have any risk with the investment.
- Traded over-the-counter: While CDSs reduce risk, they are prone to additional risk because they are traded on OTC markets.
- Seller inherits substantial risks: The CDS seller inherits the risk of the borrower defaulting.
Advantages
Can reduce risk to lenders
No underlying asset exposure
Sellers can spread risk
Disadvantages
Can give lenders and investors a false sense of security
Traded over-the-counter
Seller inherits substantial risk
What Triggers a Credit Default Swap?
The CDS provider must pay the swap purchaser if the underlying investment, usually a loan, is subject to a credit event.
Is a Credit Default Swap Legal?
Credit default swaps are not illegal, but they are regulated by the Securities and Exchange Commission and the Commodity Futures Trading Commission under the Dodd-Frank Act.
What Are the Benefits of Credit Default Swaps?
Credit default swaps are beneficial for two main reasons: hedging risk and speculation. To hedge risk, investors buy credit default swaps to add a layer of insurance to protect a bond, such as a mortgage-backed security, from defaulting on its payments. In turn, a third party assumes the risk in exchange for a premium. By contrast, when investors speculate on credit default swaps, they are betting on the credit quality of the reference entity.
The Bottom Line
Credit default swaps are sold to investors to mitigate the risks of underlying asset defaults. They were highly used in the past to reduce the risks of investing in mortgage-backed securities and fixed income products, which contributed to the Financial Crisis of 2007-2008 and the European Sovereign Debt Crisis.
Investors still use them, but trading has been significantly reduced due to regulations enacted in 2010. However, the notional amounts of global credit derivatives increased to $5 trillion (19.8% or $838 billion) in the first quarter of 2023, with credit default swaps trading at $4.3 trillion, or 86.1% of all credit derivative notional amounts.
