What are Credit Default Swaps (CDS) and how do they work?

What are Credit Default Swaps (CDS), how do they work and how to invest?

Credit swaps (CDS) have become an increasingly important financial instrument in the global credit market. These derivatives offer investors a flexible solution to manage credit risk associated with various types of financial assets, from corporate bonds to mortgage-backed securities.

Through CDS, investors can transfer the default risk of a reference entity to another party, obtaining a hedge against potential credit events.

In the post-financial crisis period, Credit Default Swaps (CDS) have hit the headlines, instruments that until then were considered obscure to most. In reality, the type of contract represented by Credit Default Swaps saw its birth in the second half of the 1990s, when the US bank JPMorgan issued the first CDS.

Credit Default Swaps have also been discussed again during the Greek crisis or the recent sell-off on European banks, with particular attention to Deutsche Bank.

Why is the price of Credit Default Swaps an indicator of risk? And, above all, what is a Credit Default Swap and how does it work?

CDS: what are Credit Default Swaps

A Credit Default Swap (CDS) contract is a derivative product allowing an investor to exchange or offset their credit risk with another investor’s. In a typical CDS agreement, the "protection buyer" pays a periodic premium to the "protection seller" in exchange for the latter’s promise to reimburse the buyer in the event of a credit event, such as the default of a reference entity.

In other words, Credit Default Swaps (CDS) are insurance for the creditor party of an underlying contract. This instrument was created for protection purposes, in practice, as we will see, it is nothing more than insurance on an event. However, the reckless use of this type of Swap in the past has caused enormous damage, playing an important role also in the subprime mortgages crisis in America.

The film “The Big Short” highlighted the role of CDS in 2008, extolling the speculative aspects of this instrument.

How Credit Default Swaps work

The operating mechanism of a CDS can be outlined as follows:

• Reference Entity: the CDS is stipulated in relation to a specific reference entity, such as a corporate bond or a government bond.
• Buyer: the investor who wishes to protect himself from the risk of insolvency of the reference entity becomes the buyer (protection buyer).
• Seller: Another party, often a financial institution or investment fund, acts as the protection seller.
• Periodic Premium: The protection buyer pays a periodic premium to the protection seller over the life of the contract.
• Credit Event: If a credit event occurs, such as the default of the reference entity, the protection seller is required to compensate the buyer for losses incurred.

This structure allows investors to transfer credit risk without having to hold the underlying asset, giving them greater flexibility in managing their portfolio.

CDSs are designed to cover a range of credit events that can trigger a payment from the protection seller to the buyer. Some of the key events typically covered in CDS contracts include:

• Reference Entity Default: The reference entity defaults on its payment obligations.
• Bankruptcy: The reference entity declares bankruptcy or is subject to insolvency proceedings.
• Debt restructuring: The terms of the reference entity’s debt are modified.
• Moratorium: The reference entity temporarily suspends payments of its obligations.
• Credit rating downgrade: The reference entity experiences a deterioration in its credit rating.

There are two main ways to settle a CDS:

• Physical settlement: The protection buyer delivers the reference asset to the seller, who pays the nominal value of the contract.
• Cash settlement: The protection seller pays the buyer the amount corresponding to the difference between the nominal value and the market value of the reference asset after the credit event.

The choice of settlement method is defined when the CDS contract is concluded.

Types of Credit Default Swaps

The CDS market can be divided into three main sectors:

• Single Credit CDS: These CDS are referenced to specific entities, such as companies, banks, or sovereign states.
• Multi-Credit CDS: These contracts allow the coverage of a customized portfolio of reference entities, agreed between the buyer and the seller of protection.
• Index CDS: Index CDS provides exposure to a basket of reference entities, often representative of a specific sector or market.

Regardless of the type, CDS can have maturities ranging from 1 to 10 years, with the 5-year contract being the most actively traded segment.

The CDS Market

The CDS market has seen significant growth in recent decades, becoming one of the largest and most important segments of the derivatives market. According to the Bank for International Settlements (BIS), the gross notional value of the global CDS market exceeded $10 trillion in 2016.

This expansion has been driven by several factors, including the need for credit risk management, arbitrage opportunities (CDS allows investors to exploit any price differences between the bond and derivatives markets), and speculative needs. Investors can use CDS to take betting positions on the creditworthiness of reference entities.

However, the role of CDS in the 2007-2008 financial crisis and the subsequent European sovereign debt crisis has raised concerns about their regulation and the systemic risks associated with this market.

Advantages of CDS

The main advantages of Credit Default Swaps are:

• Risk Management: CDS offers a tool to manage credit risk, allowing investors to transfer the risk of default to specific bonds or portfolios.
• Portfolio Diversification: CDSs allow investors to diversify their portfolios, gaining exposure to credit markets without directly holding the underlying assets.
• Liquidity Improvement: The CDS market is highly liquid, allowing investors to enter and exit positions quickly with low transaction costs.
• Speculative Opportunities: CDSs offer investors the ability to bet on the probability of default or on movements in credit spreads, potentially generating profits.
• Customization: CDS contracts can be structured to meet investors’ specific needs in terms of credit risk coverage.

Disadvantages of CDSs

The main disadvantages of Credit Default Swaps are:

• Counterparty Risk: Investors are exposed to the risk that the counterparty to the CDS contract will not be able to fulfill its obligations in the event of a credit event.
• Complexity and “opaqueness”: CDS are complex financial instruments, and their structure and operation can be difficult for less experienced investors to understand.
• Lack of regulation: In the past, the CDS market has suffered from less regulation than other financial markets, which has increased transparency and oversight risks.
• Illiquidity in times of stress: Although generally liquid, the CDS market can become illiquid during periods of financial turmoil, making it difficult for investors to close out positions or hedge adequately.

Why use CDS today

Despite concerns raised during financial crises, Credit Default Swaps continue to play an important role in the global financial market.

Here are some of the main uses of CDS today:

Credit Hedging
Investors, banks, and insurance companies use CDS to hedge against the default risk of reference entities, such as corporate bonds or government bonds.

Portfolio Diversification
CDS allows investors to diversify their portfolios, gaining exposure to credit markets without directly holding the underlying assets.

Arbitrage
Investors can exploit price differences between the bond market and the CDS market to engage in arbitrage transactions.

Speculative Activity
CDS provides opportunities for speculation on changes in the creditworthiness of reference entities and the movement of credit spreads.

However, regulation and supervision of the CDS market have been strengthened since the financial crises, in order to mitigate systemic risks and increase transparency.

Credit Default Swap after the financial crisis

After the 2008 financial crisis, the media, economists, and market operators turned their attention to Credit Default Swaps (CDS). These instruments played an important role in the subprime mortgage crisis in the United States due to their speculative use (also highlighted in the recent film “The Big Short”).

Even in recent crises, such as that of Greece or of some companies such as Deutsche Bank, CDS have returned to the forefront.

This instrument actually saw the light at the end of the 1990s when the American bank Jp Morgan issued the first Credit Default Swap. CDS are part of the broader category of Swaps and were designed for hedging purposes and not speculative purposes.

Examples of Credit Default Swap

Among the most well-known cases is the CDS of Deutsche Bank, whose price literally skyrocketed years ago as investors’ fears about the solvency of the German bank worsened. This movement on CDS, accompanied by the sell-off on stocks, forced the Teutonic institution to carry out a buyback on the Coco bonds issued to signal the market’s confidence.

Another well-known case is that of the Hellenic CDS, which reached dizzying levels after the country entered a liquidity crisis, reaching peaks where half of it was needed to insure €10 million of notional value.

The speculative use of Credit Default Swaps (CDS)

This is why there is also a speculative use of CDS since the creditor can very well decide to sell the contract, collecting the difference in premiums when he sells the contract.

In fact, through this instrument it is possible to bet on the default or otherwise of a company/State, earning on the price difference as if it were a normal stock.

In the past, the unscrupulous use of CDS led to the near bankruptcy of insurance companies, such as AIG in the USA, when credit events occurred.

In America, it caused a particular stir because numerous banks and insurance companies (which generally act as protection sellers) had stipulated CDS on bonds indexed to the real estate sector, considered very solid at the time.

When the market began to collapse, already creating problems for intermediaries due to the lack of returns on mortgages and loans, there was a liquidity crisis as the sums to be repaid by the insurance companies far exceeded the available cash.

This is why since the end of the crisis, CDS have been seen as a dark instrument, branded as " weapons of mass destruction " by Warren Buffett or "bonds to be banned" by George Soros.

In reality, these instruments were created with a precise and useful purpose, an inconsiderate use of this derivative (which amplifies the effects of a failure as a derivative) has almost ruined the entire US banking and insurance system.

Credit Default Swaps, in brief

A peculiarity of this instrument is that it is not traded on the regulated financial market but outside of it, therefore it is an OTC security (Over the Counter). Furthermore, a CDS can be stipulated both on a sovereign reference entity (for example on government bonds) and corporate (therefore corporate bonds).

Another characteristic is that the quotation of a CDS is expressed in basis points (or basis points). Each basis point is equal to 0.01% of the reference notional, so 100 basis points correspond to 1% of the insured capital.

The CDS price therefore expresses how much the protection buyer will have to give to the protection seller to insure himself on the predetermined notional and on the specific reference entity.

It is therefore immediately obvious that, as the price increases, the riskiness of the debtor increases. Leaving aside the mathematical formulas, the pricing of this derivative takes into account the probability of insolvency of the debtor and the rate of recovery of the capital for the creditor.

It is therefore not a given that the CDS follows the trend of the underlying since even the mere variation in the perception of risk on the reference entity is enough to modify its value.

Original article published on Money.it Italy 2024-08-13 19:06:28. Original title: Cosa sono i Credit Default Swap (CDS) e come funzionano