What is Credit Default Swap (CDS)?

Swetha Dhinesh

03 Jun, 2023

The main idea of CDS, which was initially to give banks a way to transfer credit exposure, has expanded to include active portfolio management. Similar to corporate bonds, CDS performance is closely correlated with changes in credit spreads. They can thus be used to take on credit exposure while effectively hedging risk efficiently. It’s believed that Blythe Masters of JP Morgan invented credit default swaps in 1994. They noticed a huge rise in popularity in the early 2000s. Let’s explore the idea of a credit default swap and its uses and associated hazards. 

Credit Default Swap (CDS)

Credit Default Swap, or CDS, is a contract between the protection buyer and seller. Investors frequently purchase Credit Default Swaps (CDS) for protection against default; these contracts are comparable to insurance contracts in that they offer the buyer protection from hazards.

By moving a bond’s risk from one party to another, where one party sells the risk, and another party buys the risk, Credit Default Swaps (CDS) are helpful in reducing the risk associated with bond investing. The risk seller gives the buyer a regular fee in exchange for ownership of the underlying credit asset. In the event of a default, the buyer reimburses the seller an agreed amount.

Credit default swaps can be held responsible for the economy’s financial stability, even though they are often employed for hedging credit risks. Credit default swaps (CDS) are designed to cover a wide range of risks, including defaults, bankruptcies, and downgrades in credit ratings.

Three segments make up the credit swap market: single-credit CDS, multi-credit CDS, and CDS index. Aside from these advantages, CDS offers access to bond liquidity, credit risk, foreign credit investment, and maturity exposure.

Purpose of Credit Default Swap 

The purpose of CDS was to allow buyers to transfer risk in the event of payment defaults. The buyer is required to make regular monthly payments to the seller, much like an insurance policy. Normally, buyers swap to protect against the default of sovereign debt, corporate bonds, and government bonds.

A credit derivative contract or instrument is another name for CDS. Derivative Contracts are formal agreements made between two people, one of whom is a buyer and the other a seller. As a result, they serve as each other’s Counterparties. In such a contract, the underlying asset will either be physically exchanged in the future or will be used as the basis for cash payoffs between the parties.

Despite being comparable, CDS and insurance are not the same. In contrast to insurance sellers, CDS vendors are not needed to be regulated entities. Although banks are the majority of CDS vendors, some sellers are less responsible. Sellers of CDS are not required to keep a reserve, unlike insurers. Therefore, in the event of a default, a CDS seller could not have enough money to reimburse the buyer.

Uses of Credit Default Swap (CDS)

Investors can purchase credit default swaps for the following reasons:

• Speculation: An investor may purchase a credit default swap from an entity on the assumption that it is either very high or low and attempt to profit from it by engaging in a transaction. Additionally, because an increase in CDS spread indicates a reduction in creditworthiness and vice versa, an investor might purchase credit default swap protection to bet on the likelihood that the company will default.
  If a CDS buyer believes that the seller’s creditworthiness will improve, he may also decide to sell his protection. The investor who purchased the protection is seen as being short the CDS and the credit, whereas the seller is seen as being long the CDS and the credit. The majority of investors feel that a CDS aids in assessing an entity’s creditworthiness.

• Arbitrage: In order to profit from a brief difference in stock prices, arbitrage is the practice of purchasing a security from one market and simultaneously selling it in another market at a substantially higher price. It is expected on the idea that there should be a negative connection between a company’s stock price and credit default swaps spread. The share price should rise, and the CDS spread should narrow if the company’s outlook improves.
  The CDS spread should increase, and the stock price should fall if the company’s outlook does not improve. For instance, an investor would anticipate a rise in CDS spread compared to the share price decline when a firm has an adverse event and its share price falls. When an investor takes advantage of the market’s sluggishness to their advantage, arbitrage may take place.

• Hedging: Investments that hedge are made to lower the risk of unfavourable price changes. Banks may enter into a CDS contract as the buyer of protection to hedge against the risk that a loanee may default. In the event of a default by the borrower, the contract’s proceeds will be applied to the defaulted debt. A bank may sell the loan to another bank or financial institution in the absence of a CDS.
  The practice, however, might harm the borrower-bank relationship because it demonstrates the lender’s lack of faith in the latter. The bank can control the default risk while keeping the loan in its portfolio by purchasing a credit default swap.
  A bank can use hedging to reduce the risk of concentration. Concentration risk exists when a single borrower accounts for a sizable portion of a bank’s customers. If just that one borrower defaults, the bank will suffer a severe loss.

By purchasing a CDS, the bank can manage the risk. Since the borrower is not a party to the CDS contract, entering into one enables the bank to accomplish its diversity goals without endangering its relationship with the borrower. Other organisations, including pension funds, insurance companies, and holders of corporate bonds, can buy CDS for a similar purpose even though CDS hedging is most common among banks.

The Risks of Credit Default Swaps

• Buyer defaulting could prevent the seller from receiving the anticipated profit.
• If the initial buyer backs out, the seller might be compelled to sell it to make up for the loss.
• This compensation can be less expensive than before.
• The seller hopes that the original buyer will pay the premium on time by collecting a monthly premium from them. However, should the original buyer default, a series of unfulfilled promises will follow, simulating the 2008 financial crisis.

Purchase of credit default swaps

Credit default swaps can be a helpful instrument for portfolio management and speculating despite their erratic past. Additionally, remember that regulations now govern the credit default swap market. Buyers may still wish to think about buying these kinds of financial instruments, even if there is still a sizable market risk connected with CDS transactions (owing to the ongoing potential that an economic collapse could result in massive defaults).

If you’re interested, it’s easy to understand how to purchase a credit default swap. They are valued by industry computer programmes and traded over the counter (OTC). Depending on the likelihood of a credit event, the swap’s value may change. If necessary, investors can terminate the agreement by selling their stake to another person or business. Credit default swap accounting is much more suitable for institutional investors than for ordinary investors because it necessitates in-depth market knowledge.

Impact of CDS on the 2008 financial crisis

• Before the 2008 financial crisis^[1], credit default swaps had more money invested than other pools.
• Compared to $22 trillion in equities, $7.1 trillion in mortgages, and $4.4 trillion in US Treasury bonds, the value of credit default swaps was $45 trillion.
• In the middle of 2010, there was $26.3 trillion worth of outstanding CDS.
• The Federal Reserve of the US had to step in since the bank’s insurer, American Insurance Group, lacked the resources to settle the debt.
• Companies that traded in swaps suffered greatly during the financial crisis.
• Due to the unregulated market, swaps were utilised to insure complicated financial items.
• Swaps lost favour with investors, and banks started to hold more capital and adopt more risk-conscious lending practices.
• The riskiest swaps were phased out, and banks were forbidden from using consumer deposits to invest in swaps and other derivatives.
• The act also called for the establishment of a clearinghouse for trade and price swaps.

Conclusion

Some claim that because Credit Default Swap derivatives are dangerous and may result in bankruptcy, they pose a risk. Unsecured Credit Default Swaps, which have no collateral, have been known to default in the past. However, they assist in shifting the liability to a third party, which is why they are so well-liked by businesses.  

Read our Article:SEBI Allowed Participation of AIFs in Credit Default Swap