Credit default swap do not hold the loan instrument and who have no direct insurable interest in the loan (these are called “naked” CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan.[2] Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion,[3] falling to $26.3 trillion by mid-year 2010[4] but reportedly $25.5[5] trillion in early 2012. CDSs are not traded on an ex- change and there is no required reporting of transactions to a government agency.[6] During the 2007-2010 finan- cial crisis the lack of transparency in this large market be- If the reference bond performs without default, the protection came a concern to regulators as it could pose a systemic buyer pays quarterly payments to the seller until maturity risk.[7][8][9][10] In March 2010, the [DTCC] Trade In- formation Warehouse (see Sources of Market Data) an- nounced it would give regulators greater access to its credit default swaps database.[11] CDS data can be used by financial professionals, regu- lators, and the media to monitor how the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies. U.S. Courts may soon be following suit.[1] Most CDSs are documented using standard forms drafted by the International Swaps and Derivatives Association (ISDA), although there are many variants.[7] In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called credit-linked notes), as well as loan-only credit default If the reference bond defaults, the protection seller pays par value swaps (LCDS). In addition to corporations and govern- of the bond to the buyer, and the buyer transfers ownership of the ments, the reference entity can include a special purpose bond to the seller vehicle issuing asset-backed securities.[12] Some claim that derivatives such as CDS are potentially A credit default swap (CDS) is a financial swap agree- dangerous in that they combine priority in bankruptcy ment that the seller of the CDS will compensate the buyer with a lack of transparency.[8] A CDS can be unsecured (usually the creditor of the reference loan) in the event of (without collateral) and be at higher risk for a default. a loan default (by the debtor) or other credit event. This is to say that the seller of the CDS insures the buyer against some reference loan defaulting. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by Blythe Masters from JP Mor- gan in 1994. In the event of default the buyer of the CDS receives com- pensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.[1] However, anyone can purchase a CDS, even buyers who 1 2 1 DESCRIPTION 1 Description CDSs can be used to create synthetic long and short po- sitions in the reference entity.[9] Naked CDS constitute most of the market in CDS.[15][16] In addition, CDSs can Protection buyer also be used in capital structure arbitrage. t1 t2 t3 t4 t5 t6 ... tn A “credit default swap” (CDS) is a credit derivative con- ... tract between two counterparties. The buyer makes peri- odic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experi- ences a similar credit event.[7][13][17] The CDS may refer t0 tn Protection seller to a specified loan or bond obligation of a “reference en- tity”, usually a corporation or government.[14] Buyer purchased a CDS at time t0 and makes regular As an example, imagine that an investor buys a CDS from premium payments at times t1, t2, t3, and t4. If the associated credit instrument suffers no credit event, then AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make reg- the buyer continues paying premiums at t5, t6 and so on until the end of the contract at time t. ular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt, the investor receives Protection buyer a one-time payment from AAA-Bank, and the CDS con- t1 t2 t3 t4 t5 tract is terminated. If the investor actually owns Risky Corp’s debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge. But investors can also buy CDS contracts referencing t 0 tn Risky Corp debt without actually owning any Risky Corp Protection seller debt. This may be done for speculative purposes, to However, if the associated credit instrument suffered a bet against the solvency of Risky Corp in a gamble to credit event at t5, then the seller pays the buyer for the make money, or to hedge investments in other compa- loss, and the buyer would cease paying premiums to the nies whose fortunes are expected to be similar to those of seller. Risky Corp (see Uses). If the reference entity (i.e., Risky Corp) defaults, one of A CDS is linked to a “reference entity” or “reference two kinds of settlement can occur: obligor”, usually a corporation or government. The ref- erence entity is not a party to the contract. The buyer • the investor delivers a defaulted asset to Bank for makes regular premium payments to the seller, the pre- payment of the par value, which is known as physical mium amounts constituting the “spread” charged by the settlement; seller to insure against a credit event. If the reference entity defaults, the protection seller pays the buyer the • AAA-Bank pays the investor the difference between par value of the bond in exchange for physical delivery the par value and the market price of a specified debt of the bond, although settlement may also be by cash or obligation (even if Risky Corp defaults there is usu- auction.[7][13] ally some recovery, i.e., not all the investor’s money A default is often referred to as a “credit event” and in- is lost), which is known as cash settlement. cludes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower’s credit rat- The “spread” of a CDS is the annual amount the protec- ing.[7] CDS contracts on sovereign obligations also usu- tion buyer must pay the protection seller over the length ally include as credit events repudiation, moratorium and of the contract, expressed as a percentage of the notional acceleration.[6] Most CDSs are in the $10–$20 million amount. For example, if the CDS spread of Risky Corp range[14] with maturities between one and 10 years. Five is 50 basis points, or 0.5% (1 basis point = 0.01%), then years is the most typical maturity.[12] an investor buying $10 million worth of protection from An investor or speculator may “buy protection” to hedge AAA-Bank must pay the bank $50,000. Payments are the risk of default on a bond or other debt instrument, re- usually made on a quarterly basis, in arrears. These pay- gardless of whether such investor or speculator holds an ments continue until either the CDS contract expires or interest in or bears any risk of loss relating to such bond Risky Corp defaults. or debt instrument. In this way, a CDS is similar to credit All things being equal, at any given time, if the maturity insurance, although CDS are not subject to regulations of two credit default swaps is the same, then the CDS governing traditional insurance. Also, investors can buy associated with a company with a higher CDS spread is and sell protection without owning debt of the reference considered more likely to default by the market, since a entity. These “naked credit default swaps” allow traders higher fee is being charged to protect against this happen- to speculate on the creditworthiness of reference entities. ing. However, factors such as liquidity and estimated loss 1.2 Risk 3 given default can affect the comparison. Credit spread 1.2 Risk rates and credit ratings of the underlying or reference obligations are considered among money managers to be When entering into a CDS, both the buyer and seller of the best indicators of the likelihood of sellers of CDSs credit protection take on counterparty risk:[7][12][22] having to perform under these contracts.[7] • The buyer takes the risk that the seller may default. If AAA-Bank and Risky Corp. default simultane- 1.1 Differences from insurance ously ("double default"), the buyer loses its protec- tion against default by the reference entity. If AAA- CDS contracts have obvious similarities with insurance, Bank defaults but Risky Corp. does not, the buyer because the buyer pays a premium and, in return, receives might need to replace the defaulted CDS at a higher a sum of money if an adverse event occurs. cost. However there are also many differences, the most im- • portant being that an insurance contract provides an in- The seller takes the risk that the buyer may default demnity against the losses actually suffered by the policy on the contract, depriving the seller of the expected holder on an asset in which it holds an insurable inter- revenue stream.