Credit default swaps (CDSs) are derivatives, financial instruments sold over the counter. They transfer the credit risk associated with corporate or sovereign bonds to a third party, without shifting any other risks. European politicians have blamed the CDS market for destabilising Greece, and as a result, there is a new EU Regulation that restricts the use of ‘naked’ CDSs on sovereign (but not corporate) debt. These contracts offer payment on default of a financial instrument even if the buyer of the contract does not hold the underlying bonds.
The original use of a CDS contract was to provide insurance against unexpected losses due to a default by a corporate or sovereign entity. This is a bilateral deal where a ‘protection buyer’ pays a periodic fixed premium, usually expressed in basis points of the reference asset's nominal value, to a counterpart known by convention as the ‘protection seller’. The total amount paid per year as a percentage of the notional principal is known as the CDS spread.
The outstanding gross notional value of live positions of CDS contracts stood at $15 trillion on 31 August 2011 across more than 2 million trades.2 Most of these are on corporate (financial and non-financial) debt, but the sovereign segment has risen since the Eurozone crisis and is 15%–20% of the market now.
The CDS market may be regarded as a useful financial innovation, unless it (a) does not isolate credit risk efficiently; (b) is dominated by ‘naked CDSs’ that perform no hedging function and serve merely to make bets on the future of corporates and sovereigns that can destabilize them.
Read more: Credit Default Swaps: Useful, Misleading, Dangerous?, 30 April 2012 Monday 10:26
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