Credit Default Swap, Example & Importance

Credit Default Swaps (CDSs) are one of the biggest financial innovations of the modern markets. They have given institutions a way to manage credit risk better. But they have also been linked to big financial crises so we need to understand how they work and what they mean.

What is Credit Default Swap?

A Credit Default Swap (CDS) is a financial derivative that works like an insurance contract. In simple terms a CDS is an insurance against the default of a reference instrument, usually a bond or loan. The buyer of a CDS pays premiums to the seller and in return the seller will pay the buyer if the issuer of the reference instrument defaults.

This allows for the transfer of credit risk from one party to another. For example a bank has a portfolio of loans, it can enter into a CDS to hedge against the risk of those loans defaulting. By doing so the bank is transferring the risk to the CDS seller, often an institutional investor.

Example of Credit Default Swap

Let’s take a practical example:

A bank issues loans to various businesses. The bank is worried about the default of those loans which could lead to big financial losses. To mitigate this risk the bank enters into a CDS contract with an institutional investor. In this contract the bank agrees to pay the institutional investor a quarterly premium. In return the institutional investor will guarantee that if any of the bank’s borrowers default the investor will pay the defaulted amount.

For example if the bank has issued a $10 million loan to a company and that company defaults, the investor will pay the bank $10 million minus any recoveries. This allows bank to continue lending. There is no fear of big losses due to defaults.

How Credit Default Swaps Work

To fully understand CDSs we need to get into the mechanics 

Premium Payments: The buyer of CDS pays the seller regularly. These payments are like insurance premiums and are usually quarterly. The size of these payments depends on the risk of the reference instrument. Higher risk means higher premiums 

Credit Events: A CDS contract defines what is credit event. Common credit events are bankruptcy failure to pay and restructuring. If any of these events happen the CDS seller will pay the buyer 

Settlement: When a credit event happens the CDS can be settled in two ways: physical settlement or cash settlement. In physical settlement the buyer delivers the defaulted instrument to the seller. The buyer gets the face value in return. In cash settlement the seller pays the buyer the difference between the face value and the market value of the defaulted instrument.

Why Credit Default Swaps

Credit Default Swaps are important for the financial markets for three reasons 

Risk Management: CDSs allow institutions to manage and hedge their credit risk. By passing the risk to someone else they can avoid big losses 

Price Discovery: The CDS market provides valuable information about the creditworthiness of issuers. The premium paid for a CDS is market’s view of the risk of the reference instrument. Investors and regulators can use this information to measure credit risk 

Liquidity: CDSs provide market liquidity by allowing institutions to trade credit risk. This liquidity helps to stabilize the system by spreading credit risk among market participants

Credit Default Swaps and the Financial Crisis

Despite their benefits, Credit Default Swaps have also been linked to big financial problems. The most obvious example is the Financial Crisis of 2008-2009  In the years leading up to crisis many financial institutions bought CDSs to hedge their exposure to mortgage-backed securities (MBS). But the widespread use of CDSs had unintended consequences

Moral Hazard: The availability of CDSs led to decline in underwriting standards. Lenders became more willing to issue bad loans. They knew they could pass the credit risk to CDS sellers. This behaviour contributed to housing bubble and collapse of mortgage market. 

Counterparty Risk: The interconnectedness of financial institutions through CDS contracts created big counterparty risk. When big institutions like Lehman Brothers failed, their inability to honour CDS contracts caused a chain reaction of losses throughout the system.

Lack of Transparency: The CDS market was opaque and unregulated. This lack of transparency meant regulators and market participants couldn’t measure the true risk in the system. So when a few key institutions failed, the impact was huge.

Regulatory Response and Reforms

In response to the crisis, regulators introduced several reforms to fix the problems with Credit Default Swaps:

Central Clearing: One of the big reforms was the introduction of central clearing for standardized CDS contracts. Central clearinghouses act as intermediaries between buyers and sellers, reducing counterparty risk and increasing transparency.

Increased Transparency: Regulators required more transparency in the CDS market. Market participants must now report CDS trades to regulators, so there’s better oversight and less hidden risk.

Capital Requirements: Institutions that trade CDSs have stricter capital requirements. These requirements mean institutions have enough capital to cover potential losses from CDS contracts, so they can’t go bust.

Conclusion

Credit Default Swaps are important financial tools that help manage credit risk and provide market liquidity. But their abuse and the opacity of the CDS market caused the Financial Crisis of 2008-2009. You should know how CDSs work. While regulatory reforms have addressed many of the issues associated with CDSs, ongoing vigilance is necessary to ensure that these derivatives continue to serve their intended purpose without posing undue risk to the financial system.