Credit Default Swap

Financial Dictionary -> Investing -> Credit Default Swap

A CDS or a credit default swap is a contract that aims to transfer the financial risk from one entity to another. In order for a company to pass on the risk to another entity, it buys a credit default swap from a seller. The latter gets premiums from the buyer for the whole duration of the contract, but runs the risk of paying the face value of the credit instrument in case the borrower defaults. This happens because the seller assumes the risk of default instead of the buyer.

How It Works

The concept of credit default swap may seem quite vague to many people, but the process is, in fact, very simple. Let us say that Sally needs to borrow $100 from John. After this informal transaction, John does not want to assume the risk of default, and in order to manage the risk, he agrees to pay Jane premiums as long as she assumes that risk. Having studied the credit history of Sally, Jane agrees to pay the face value of the loan in case Sally defaults.

When the payment on the loan is due, however, Sally is unable to secure the whole amount because she was fired from work. John decides to go to Jane and ask her to pay for the face value of the loan instead. In this case, John has made a good deal, while Jane suffers the consequence of paying for Sally's debt.

Problems with CDS

The concept of CDS was developed by JP Morgan in the 1990's as to allow financial institutions to transfer financial risks of credit instruments to other entities. Unlike insurance, CDS is largely unregulated and in the year 2008, many issues began to emerge. Because the contract is transferable, tracking it down to the person who is in possession can be a problem. If the borrower defaults, the contract has to be tracked down to the last person it has been transferred to. The seller of the CDS is not required to show a proof of ability to pay for the total amount of the insured debt, and there is a high chance that he may not be able to cover for it as well.

During the recent economic recession, many companies have faced the problem of selling CDS. Even corporate giants like AIG were unable to cover the amounts of their CDSs. Because of the hundreds and thousands of homeowners going into default, those who entered into CDS contracts were pressured by the catastrophic economic event.

CDS Is not Insurance

Technically, the credit default swap is not a type of insurance. Although it has been compared to insurance for a variety of reasons, the underlying concepts behind the two are simply quite different. For one thing, insurances are regulated while the CDS is not. Buyers don't need to own the underlying security and don't incur losses in case of default. Credit default swaps are not traded on the exchanges, and the reporting of transactions to governmental agencies is not required. In the US, CDSs are most often subject to mark-to-market accounting, with balance sheet volatility and income statement that are not present in insurance contracts. In addition, insurance comes with the disclosure of all potential risks, while none of these requirements is valid for CDSs.