What Is a Credit Default Swap and How Does It Work?

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.

How Credit Default Swaps (CDSs) Work

A credit default swap is a derivative contract that transfers the credit exposure of fixed income products. 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-year maturity to 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, the investor assumes 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.

Debt securities often 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 the CDS seller until the contract's maturity date. In return, the CDS seller agrees that it will pay the CDS buyer the security's value as well as all interest payments that would have been paid between that time and the maturity date if there is a credit event.

Credit Default Swaps and Credit Events

The credit event is a trigger that causes the CDS buyer to settle the contract. Credit events are agreed upon when the 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

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.

When Are CDSs Used?

As an insurance policy 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.

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.

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.

Mechanics of Credit Default Swaps

The settlement process of credit default swaps involves several mechanisms aimed at determining the compensation owed to the protection buyer in the event of a credit event. There are two main methods of settlement: physical settlement and cash settlement.

In physical settlement, the protection buyer receives the underlying debt securities from the protection seller upon the occurrence of a credit event. The notional amount of the CDS contract represents the face value of the underlying debt securities. The protection buyer can then either hold the bonds as an investment or sell them in the secondary market.

In cash settlement, the compensation owed to the protection buyer is determined based on the results of a credit event auction conducted by a designated auction administrator. The auction aims to establish a market-based price for the defaulted debt securities. The final price is then used to calculate the cash settlement amount. Cash settlement is generally preferred in situations where there is limited liquidity in the underlying bond market.

Advantages and Disadvantages of CDSs

Pros of Credit Default Swaps

Credit default swaps offer several advantages for investors and institutions:

• Risk Management: CDS are a tool for managing credit risk. Investors can use CDS contracts to hedge against the risk of default on specific bonds or portfolios of bonds.
• Portfolio Diversification: CDS allow investors to diversify their portfolios by providing exposure to credit markets without directly owning the underlying bonds. This diversification can help reduce overall portfolio risk as CDS contracts offer flexibility in targeting specific credit exposures across different sectors and regions.
• Liquidity Enhancement: CDS markets are highly liquid, offering investors the ability to enter and exit positions quickly with minimal transaction costs. This liquidity can be particularly valuable in times of market stress when investors need to adjust their credit exposures swiftly.
• Speculative Opportunities: CDS provide investors with opportunities for speculation and profit generation. Through CDS contracts, investors can take directional views on credit markets, betting on the likelihood of default or changes in credit spreads.
• Customization: CDS contracts can offer flexibility in structuring credit protection to meet specific investor needs. Investors can pick CDS contracts to hedge against exposure to individual bonds, portfolios, or even customized credit indices depending on their risk appetite.

Disadvantages Explained

While credit default swaps offer the advantages above, they also come with several downsides:

• Counterparty Risk: One of the primary downsides of CDS is the exposure to counterparty risk. If the seller of the CDS defaults or fails to fulfill its obligations, the buyer may incur significant losses. We'll discuss counterparty risk more in the next section.
• Complexity and Opacity: CDS contracts can be highly complex financial instruments. The intricate terms and conditions that may be difficult for investors to fully understand. The lack of transparency in some aspects of the CDS market make it tough for novice investors to fully understand what they're getting into.
• Lack of Regulation: Historically, the CDS market has been less regulated compared to other financial markets. This means there can be less transparency and oversight, leading to higher risk. The absence of centralized clearinghouses and reporting requirements for CDS transactions can exacerbate these issues.
• Illiquidity During Stressful Periods: While the CDS market is generally liquid under normal market conditions, liquidity can deteriorate rapidly during periods of financial stress or market turmoil. This illiquidity can exacerbate price volatility and make it challenging for investors to unwind their positions or hedge their exposures effectively, especially during a time where exiting a position at a specific time may come with material financial consequences.

Credit Default Swaps and Counterparty Risk

As mentioned above, counterpart risk represents the risk that the other party in the CDS contract will default on its obligations. In the context of CDS, counterparty risk arises because these contracts are typically traded over-the-counter between two parties without the oversight of a centralized exchange.

In a CDS contract, the protection buyer pays regular premiums to the protection seller in exchange for protection against credit events affecting a specified reference entity. If a credit event occurs, such as the default of the reference entity, the protection seller is obligated to compensate the protection buyer for the losses incurred. However, if the protection seller defaults, the protection buyer may not receive the compensation owed, exposing them to the full credit risk associated with the reference entity. Therefore, there is investment risk not necessarily with the product being held but with the entity in which it is associated with.

Investors can employ various strategies to manage counterparty risk effectively. They can (and should) conduct due diligence on potential counterparties to assess their financial health and creditworthiness. They can diversify counterparty exposure by spreading trades across multiple counterparties. They can use collateral agreements and credit support annexes to secure their positions and require counterparties to post collateral as security against potential losses.

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.