The credit default swap (CDS) is designed to transfer credit exposure between parties. The buyer of the credit swap basically receives credit protection while the seller guarantees the worthiness of the credit product. This technique effectively transfers the default risk from the holder of the fixed income security to the seller. In exchange, the buyer needs to make regular payments to the seller if their financial product defaults.

Credit default swaps have been likened to insurance products in the sense that the buyer needs to pay premium in return for receiving a certain sum of money if default occurs. It is important to point out that there are significant differences between an insurance product and a credit default swap. The major difference is the fact that the buyer does not need to own the underlying credit product. In fact, he might not even suffer from financial losses in the event of bankruptcy or restructuring.

Sophisticated investors typically buy credit default swaps to grow their investments. For example, imagine that a person buys a CDS instrument from XYZ Bank where the reference institution is the AB Company. The buyer will need to make consistent payments to the Bank and if the AB Company defaults on its obligations, the person who bought the instrument will receive a one-off payment from the XYZ Bank. On the other hand, if the “buyer” owns the AB Company debt, the CDS can be described as hedging.

The Cost of Protecting Credit

Today, there are many concerns about the real cost of protecting credit. Instruments such as collateralized debt obligations have undermined the entire economy. Credit default swaps, another form of protecting credit, is now under scrutiny.

The CDS market achieved phenomenal growth over the past decade and it hit over $45 trillion in 2007. This figure is twice the size of the stock market in the United States and it far exceeds the figure from the mortgage market. If the CDS industry fails, it can be the “nail in the coffin” for the economy. CDS basically promises to cover losses on selected securities and it encompasses a broad range of products from corporate debts, municipal bonds, to mortgage securities. It is sold by banking institutions and hedge fund among others.

Supposedly, the CDS was conceptualized to work like a home insurance except that actually don’t. Insurance companies and banks are regulated while the credit default swap market isn’t. Because of this, contracts can be traded among investors without oversight. It is difficult to determine if the buyer actually has sufficient resources in the case of the default. In addition, the CDS can be bought and sold by both the insured and the issuer.

A lot of banks are heavily invested in this industry. In fact, commercial backs are actually the most active with the top 25 banks holding over $13 trillion in CDS alone. CDS was seen as “easy money” when it was introduced because defaults were unlikely back then, but that was in the 1990 when the swaps were focused on corporate debts and municipal finance. It has been structured as finance securities since then and it is now among one of the most risky ventures that a person can get into.