What is Credit Default Swap (CDS)?

Credit Default Swaps (CDS) Definition

Credit default swaps (CDS) are insurance-like contracts in which the buyer of the CDS makes certain payments to the seller in exchange for the promise to receive a payoff in the event of a default.

Credit default swaps typically apply to corporate debt, municipal bonds, and mortgage securities, can be bought by any investor even if the buyer does not own the particular credit instrument, and are sold by banks, hedge funds and others.

Credit Default Swaps (CDS) Explained

Consider the following example:

The investor A buys a CDS from the bank B to cover the losses in case the company X defaults. In this case, the investor owns the X company debt. Thus, the investor A starts making regular payments to the bank B and if X defaults on its debt and fails to repay it, the bank B will pay one-off payment to the investor A. At that point the CDS contract is terminated.

When the company X defaults, either the investor A delivers the defaulted asset to the bank B for a payment of the par value (known as physical settlement), or the bank B pays the investor the difference between the par value and the market price of the debt obligation of the X company (known as cash settlement).

However, the investor is not required to own any debt in order to buy CDS. Thus, buying CDS contracts is very often done for speculative purposes. Investor A buys a CDS contract and bets against the solvency of the company X in order to make money if it defaults.

Credit Default Swaps Regulation

Credit default swaps work much like insurance but in contrast to banks and insurance companies, the credit swaps market is not regulated.

CDS can be traded from investor to investor unregulated. No one oversees the trades of CDS and ensures that there are enough resources to cover losses if the particular security defaults.

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