What Is a Credit Default Swap (CDS)?

A credit default swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.

Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy. A lender who is worried about a borrower defaulting on a loan often uses a CDS to offset or swap that risk.

How Credit Default Swaps (CDSs) Work

A credit default swap is a derivative contract that transfers the credit exposure of fixed income products. It may involve bonds or forms of securitized debt—derivatives of loans sold to investors.

Because the debt issuer cannot guarantee that it will be able to repay the premium, the investor assumes the risk. The debt buyer can purchase a CDS to transfer the risk to another investor, who agrees to pay them in the event the debt issuer defaults on its obligation.

Debt securities often have longer terms to maturity, making it harder for investors to estimate the investment risk. For instance, a mortgage can have terms of 30 years. There is no way to tell whether the borrower will be able to continue making payments that long.

That's why these contracts are a popular way to manage risk. The CDS buyer pays the CDS seller until the contract's maturity date. In return, the CDS seller agrees that it will pay the CDS buyer the security's value as well as all interest payments that would have been paid between that time and the maturity date if there is a credit event.

Credit Events

The credit event is a trigger that causes the CDS buyer to settle the contract. Credit events are agreed upon when the CDS is purchased and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers:

• Reference entity default other than failure to pay: An event where the issuing entity defaults for a reason that is not a failure to pay
• Failure to pay: The reference entity fails to make payments
• Obligation acceleration: When contract obligations are moved, such as when the issuer needs to pay debts earlier than anticipated
• Repudiation: A dispute in the contract validity
• Moratorium: A suspension of the contract until the issues that led to the suspension are resolved
• Obligation restructuring: When the underlying loans are restructured
• Government intervention: Actions taken by the government that affect the contract

Terms of a CDS

When purchased to provide insurance on an investment, CDSs do not necessarily need to cover the investment for its lifetime. For example, imagine an investor is two years into a 10-year security and thinks that the issuer is in credit trouble. The bond owner may buy a credit default swap with a five-year term that would protect the investment until the seventh year, when the bondholder believes the risks will fade.

Settlement

When a credit event occurs, the contract may be settled physically, historically the most common method, or by cash. In a physical settlement, sellers receive an actual bond from the buyer. Cash settlement, though, became the more preferred method when the purpose of CDSs shifted from hedging tools to speculation. In this type of settlement, the seller is responsible for paying the buyer for losses.

When Are CDSs Used?

As an insurance policy against a credit event on an underlying asset, credit default swaps are used in several ways.

Speculation

Because swaps are traded, they naturally have fluctuating market values that a CDS trader can profit from. Investors buy and sell CDSs from each other, attempting to profit from the difference in prices.

Hedging

A credit default swap by itself is a form of hedging. A bank might purchase a CDS to hedge against the risk of the borrower defaulting. Insurance companies, pension funds, and other securities holders can purchase CDSs to hedge credit risk.

Arbitrage

Arbitrage generally involves purchasing a security in one market and selling it in another. CDSs can be used in arbitrage—an investor can purchase a bond in one market, then buy a CDS on the same reference entity on the CDS market.

The Great Recession

CDSs played a key role in the credit crisis that eventually led to the Great Recession. Credit default swaps were issued by American International Group (AIG), Bear Sterns, and Lehman Brothers to investors to protect against losses if the mortgages that were securitized into mortgage-backed securities (MBS) defaulted.

Mortgages were given to nearly anyone that requested them because investment banks and real estate investors were generating huge returns as housing prices continued to climb. CDSs allowed investment banks to create synthetic collateralized debt obligation instruments, which were bets on securitized mortgage prices.

Many investment banks issued MBSs, CDSs, and CDOs: they were all betting on the performance of their own mortgage security derivatives. When housing prices collapsed, the big players could not pay all of their obligations because they owed each other and investors more money than they had.

European Sovereign Debt Crisis

Credit default swaps were widely used during the European sovereign debt crisis. For example, investors purchased Greece's sovereign debt through sovereign bonds to help the country raise money. They also purchased CDSs to protect their capital in case the country defaulted.

Portugal, Ireland, Italy, Cyprus, and Spain all nearly collapsed financially during this time.

Advantages and Disadvantages of CDSs

Advantages Explained

• Reduces risk to lenders: CDSs can be purchased by the lender, which acts as a form of insurance designed to protect the lender and pass the risk on to the issuer.
• No underlying asset exposure: You're not required to purchase underlying fixed-income assets.
• Sellers can spread risk: CDSs pass the risk of defaulting on payments to the issuer. They can also sell multiple swaps to spread risk further.

Disadvantages Explained

• Can give lenders and investors a false sense of security: Investment insurance makes investors feel they don't have any risk with the investment.
• Traded over-the-counter: While CDSs reduce risk, they are prone to additional risk because they are traded on OTC markets.
• Seller inherits substantial risks: The CDS seller inherits the risk of the borrower defaulting.

The Bottom Line

Credit default swaps are sold to investors to mitigate the risks of underlying asset defaults. They were highly used in the past to reduce the risks of investing in mortgage-backed securities and fixed income products, which contributed to the Financial Crisis of 2007-2008 and the European Sovereign Debt Crisis.

Investors still use them, but trading has been significantly reduced due to regulations enacted in 2010. However, the notional amounts of global credit derivatives increased to $5 trillion (19.8% or $838 billion) in the first quarter of 2023, with credit default swaps trading at $4.3 trillion, or 86.1% of all credit derivative notional amounts.