What are credit default swaps?

A credit default swap, or CDS for short, is a special kind of financial deal. It’s a bit like insurance. Here’s how it works:

Let’s say there are two people involved, Alex and Bob. Bob is worried that a company (or country or some other borrower) might not pay back money it owes. That borrower is called the “underlying reference credit”.

So Alex makes a deal with Bob. Alex says hey, I’ll take on that risk for you. You pay me some money every month (a “premium”). And if that borrower actually can’t pay back what they owe (in other words, if they “default”), then I’ll pay you a big chunk of money (a “lump-sum”) to help cover your losses.

That monthly payment that Bob gives Alex is usually based on some floating interest rate. It can bounce up or down. But the big payment that Alex gives Bob if there’s a default is a set amount. It depends on how much people think the borrower’s debt is worth after they default.

So in a nutshell, CDSs are deals where one person takes on the default risk of a borrower for someone else. In exchange for monthly payments. It’s all about shifting around who takes the hit if a borrower can’t pay up.

What can have CDSs?

You can buy and sell CDSs on all sorts of things. The simplest ones are based on a single borrower defaulting, like a particular company or country. Those are called “single name” CDSs.

But CDSs get fancier too. You can get them on bundles of things, like indexes that track a whole bunch of different borrowers. The most famous are probably CDS indexes.

CDSs can also cover structured assets. That’s a fancy way of saying really complicated financial stuff, like securities backed by assets (ABS), securities backed by mortgages (MBS), or other structured notes. Those tend to involve a whole mess of loans and other assets all pooled and chopped up together.

How are CDSs traded?

Here’s the key thing about CDSs – they’re “over-the-counter” (OTC). That means they’re not traded on big official exchanges like stocks are. There’s no central place or organization overseeing the buying and selling. Instead, it’s all done privately. It’s just between the two people making the deal.

Because it’s OTC, there’s a lot of flexibility and customization possible with CDSs. The two sides can really tailor the details to what they need. But that lack of standardization and central clearing also makes the CDS market a bit more Wild West. It can be harder to know what’s a fair price, or to find someone to take the other side of your trade.

How are they similar to other things?

CDSs have a lot in common with some other financial tools. The big one is credit default options. Just like a CDS, a credit default option pays out a lump sum if a borrower defaults.

The main difference is that an option only gives you the right to get that lump sum. You don’t have to if you don’t want to. With a CDS, that lump sum payout is locked in. It’s going to happen whether the CDS buyer wants it at that point or not.

CDSs are also pretty similar to insurance in a lot of ways. They’re all about transferring the risk of something bad happening (like a default) to someone else. And you pay to make that happen. It’s a lot like paying premiums to an insurance company to take on the risk of something you own getting damaged.

But there are some big differences between CDSs and regular insurance too. For one, with insurance, you usually can only insure something if you actually own it. With CDSs, you can buy and sell default protection even if you don’t own the underlying debt. It’s a bit like being able to buy car insurance on someone else’s car.

The other big difference is regulation. Insurance is super heavily regulated pretty much everywhere, with all sorts of rules on who can sell it and what it has to look like. But the CDS market is much, much less regulated. That’s another reason they’re seen as riskier.

Why do people use CDSs?

There are a couple main reasons people use CDSs. The first is pretty straightforward – to protect against the risk of a borrower defaulting. This could be a simple case, like a bank buying a CDS on a loan it made. They’re worried the loan won’t get paid back, so they pay someone else to take on that risk by buying a CDS.

The second big reason is speculation. You don’t have to actually own a borrower’s debt to buy or sell a CDS on it. So a lot of people trade CDSs without having any direct stake in whether the borrower defaults. They’re just betting on the likelihood of it happening. If they think the chance of default looks low, they might sell CDS protection to get those monthly premium payments. If they think the chance looks too high, they might want to buy protection. It can be a purely speculative play for them.

The last main reason is arbitrage. Sometimes CDS prices can get out of whack with the underlying debt they’re based on. When that happens, nimble traders can try to exploit those discrepancies to make money.

What risks do they have?

CDSs definitely aren’t risk-free for anyone involved. For the seller of the CDS (the one taking on the default risk), the big danger is pretty obvious – that they’ll have to shell out a lot of money if there actually is a default. That payout can sometimes be a lot bigger than all the monthly premiums they got from the CDS buyer.

But CDS buyers face risks too, even if they’re the ones getting rid of the default risk. One issue is something called “counterparty risk”. Even if they’re right and a default happens, they need the CDS seller to actually be able to pay up. If the seller goes bust too, then the buyer might be out of luck.

There’s also a worry about broader impacts of CDSs. They tie a lot of people together around these credit risks. If something really big defaults, it can send really big ripples through the system. A lot of people worry that could lead to a financial crisis in a worst-case scenario, kind of like what happened in 2008.