A credit default swap, or CDS, is a contract exchange that transfers between two parties the exposure of credit to fixed income products. Two parties are involved in this exchange. The purchaser of a credit default swap obtains protection for credit. The seller of this credit default swap actually guarantees the product’s credit worthiness. In this process, the default risk moves from the owner of the fixed income security over to the party that sells the swap.
In these CDS transfers, the purchaser of the protection gives a series of fees or payments to the seller. This is also known as the spread of the Credit Default Swap. The party selling the protection gets paid off in exchange for this, assuming that a loan or bond type of credit instrument suffers from a negative credit event.
In the most basic forms, Credit Default Swaps prove to be two party contracts arranged between sellers and buyers of credit protection. These Credit Default Swaps will address a reference obligor or reference entity. These are typically governments or companies. The party being referenced is not involved in the contract as a party or even necessarily aware of its existence. The purchaser of such protection then pays pre defined quarterly premiums, or the spread, to the party who is selling the protection.
Should the entity that is referenced then default, the seller of the protection pays the face value of the instrument to the buyer of the protection against a physical transfer of the bond. Such settlements can also be accomplished by auction or in cash. Defaults in Credit Default Swaps are called credit events. These defaults might include a bankruptcy, restructuring of the referenced entity, or a failure to make payment.
Credit Default Swaps are much like insurance on credit. The difference between them and such insurance lies in the fact that a CDS is not regulated like life insurance or casualty insurance is. Besides this, investors are capable of purchasing or selling this type of protection without having any such debt of the entity that is referenced. Resulting naked credit default swaps permit investors to engage in speculation on issues of debt and credit worthiness of entities that are referenced. These naked Credit Default Swaps actually make up the majority of the CDS market.
The majority of Credit Default Swaps prove to be in the ten to twenty million dollar range. They typically have maturities ranging from one to ten years. The Credit Default Swap market is mostly unregulated and turns out to be the largest financial market on earth.
These CDS products were actually created in the early part of the 1990’s. The market for them grew dramatically beginning in 2003. By the conclusion of 2007, the total amount of them in existence proved to be an astonishing $62.2 trillion dollars. This amount declined to $38.6 trillion in the wake of the financial crisis at the conclusion of 2008. Since then, it has been growing alarmingly again. Critics of Credit Default Swaps have consistently referred to them as financial weapons of mass destruction, capable of blowing up the financial system and world economies in the process.