Credit Default Swap

A credit default swap is a contract between two parties concerning a credit risk — that is, the risk that someone will fail to repay their debt. One side pays regular amounts, similar to insurance premiums. In exchange, the other side commits to paying a large sum if a specific borrower — for example a company or a state — actually becomes insolvent. If this does not happen, the risk-taking side simply keeps the premiums. The name sounds technical, but a simple logic lies behind it: the default risk is “swapped” — that is, exchanged — for regular payments.

The Role of CDS in the 2008 Financial Crisis

Credit default swaps became famous worldwide through the 2008 financial crisis. Until then, they were considered a useful tool for banks. A bank that lends to a company bears the risk that the company goes bankrupt. With a CDS, it could pass this risk on to someone else — theoretically giving it more room to extend further loans.

The problem: many CDS were not entered into by parties that actually bore the underlying risk. Speculators used them to bet on the collapse of companies — without being affected themselves if nothing happened. The total value of all outstanding CDS contracts temporarily exceeded 60 trillion US dollars. When many borrowers defaulted simultaneously, the risk sellers could no longer fulfill their promises. The insurance company AIG had to be bailed out by the US government in 2008 because it had accumulated too many CDS obligations.

Structure and Process of a CDS Contract

A CDS contract always has three elements: a reference entity, a term, and a premium. The reference entity is the borrower whose default is being hedged against — for example, a specific Italian government bond or a Volkswagen corporate bond. The term is usually between one and ten years. The premium, often called the “spread,” is measured in basis points: 100 basis points correspond to an annual payment of one percent of the insured amount.

If a so-called credit event occurs — for example, default, debt restructuring, or insolvency — the risk seller pays the buyer the agreed amount. In exchange, the buyer hands over the now nearly worthless bonds of the defaulted borrower. If no credit event occurs, the contract expires, and the buyer has only lost their premiums. The risk seller has earned these premiums without having to pay out.

An important difference from genuine insurance: with insurance, you must be personally affected. Anyone insuring their house must own the house. With a CDS, there is no such requirement. Anyone can buy a CDS on any borrower — even without owning a single bond of that borrower. This variant is called a “naked CDS” and has been banned in the EU for government bonds since 2012.

CDS as a Risk Barometer in the Financial Press

In financial news, credit default swaps usually appear as sentiment indicators. If a country’s CDS spreads rise sharply, it means: the market considers a default more likely. During the European debt crisis starting in 2010, journalists daily monitored the CDS spreads of Greece, Portugal, and Spain — they were seen as a real-time indicator of how nervous the markets were.

The same applies to companies. When a large company runs into trouble, its CDS spreads often jump before the stock price reacts. Professional investors therefore watch the CDS market very closely. For retail investors, direct trading in CDS is hardly accessible — the contracts are not traded on exchanges but directly between large financial institutions, which makes them not very transparent.