Credit default swap

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments (the CDS 'fee' or 'spread') to the seller and, in exchange, may expect to receive a payoff if the asset defaults. In the event of default, the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan or its market value in cash. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called 'naked' CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction. The payment received is often substantially less than the face value of the loan. Credit default swaps in their current form have existed since the early 1990s, and increased in use in the early 2000s. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010 and reportedly $25.5 trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007–2010 financial crisis the lack of transparency in this large market became a concern to regulators as it could pose a systemic risk. In March 2010, the Depository Trust & Clearing Corporation (see Sources of Market Data) announced it would give regulators greater access to its credit default swaps database. CDS data can be used by financial professionals, regulators, and the media to monitor how the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies. U.S. Courts may soon be following suit. Most CDSs are documented using standard forms drafted by the International Swaps and Derivatives Association (ISDA), although there are many variants. In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset-backed securities. Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency. A CDS can be unsecured (without collateral) and be at higher risk for a default. A CDS is linked to a 'reference entity' or 'reference obligor', usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the 'spread' charged by the seller to insure against a credit event. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction.