A credit default swap (also known for its term in English, credit default swap or CDS) is a financial product that is a financial hedging of risks, including within the product category credit derivatives, which is embodied by a swap contract (swap) on a particular credit instrument (usually a bond or a loan) in which the swap buyer makes a series of periodic payments (called a spread) to the seller and, in return, receives from the latter a amount of money in case the title that serves as the underlying asset to the contract is unpaid at maturity or the issuing entity incurs suspension of payments.
Although a CDS is similar to an insurance policy, it differs significantly from it in that it is not required that the buyer of the CDS is the owner of the title (and therefore has incurred the actual risk of debt purchase). That is, an insurance is established on something that is owned by the insured, but a CDS is made on a property that is not owned by the one that contracts the CDS. This type of CDS is called "naked" (naked), and is actually equivalent to a bet. The European Parliament banned the "naked" CDS from state debt as of December 1, 2011.
- Credit default swaps are Over The Counter (OTC) traded products, that is, they are not traded in an organized official market. They are contracts made to measure between the two contracting parties. The international association of derivatives market operators ISDA provides models of this type of contracts.
- The so-called underlying assets on which these swaps are issued are any loan or debt title as an obligation or a bond, both private and public.
- The organization or company issuing the underlying securities is referred to as the reference entity.
- There is no regulation on these operations in almost any country.
- The main theoretical purpose of credit default swaps is to serve as insurance for the holder of a debt security that wants to be covered by the possible credit risk (basically unpaid) thereof. For this, he goes to a seller of credit default swaps, to whom he pays an annual premium, and in case of default, the seller responds by paying the amount of the title to the possessor.
- Although the credit default swaps have some elements in common with insurance operations, they are not regulated within the insurance activities and, thus, the selling entities do not have to comply with any of the solvency nor reserve rules that govern the year. of insurance activity, there being a greater risk of default than in insurance contracts regulated as such.
- They are called short credit default swaps (or naked CDS) to those cases in which someone signs a credit default swap contract without being the holder of any security they want to insure. In these cases, the purpose of the operation is to speculate on the evolution of the underlying assets and there may be a paradoxical case that more credit default swaps are issued than existing securities. For example, an issuance of 1,000 bonds is made and, nevertheless, there are 20,000 credit default swaps, insurance contracts on those bonds.
- As in all swap or exchange contracts, the settlement can be made either with the physical swap or settlement, in which the buyer delivers the bonds to the seller and the latter pays the amount fixed to the buyer, or by a second form, denominated liquidation by differences, consisting in that the seller only pays to the buyer the loss of value of the titles.
Among the benefits of CDS we can mention:
- It establishes an instrument for those who can manage credit risk.
- Trading in these instruments reveals information about the credit risk.
- Create a more flexible and efficient financial system than 25 years ago.
Among the costs and negative aspects we have:
- They can create bubbles that end in financial crises.
- Confidence in financial markets is lost.
- Lack of transparency in the markets that makes its manipulation possible.
The credit default swaps are the subject of debate during the 2008 financial crisis, as they were used as instruments to attack the public debt of some countries, such as Greece, in 2010. They were also responsible for the fall in 2008 of the American American International Group (AIG). Some European leaders, such as German Chancellor Angela Merkel, have been in favor of prohibiting in the European Union and the G20 credit default swaps that can be used speculatively to bet against the states. The vulture funds can effectively speculate with the price of the debt bond, while at the same time betting on the eventuality of a cessation of payments by the issuing country, obtaining extra income in case of materialization.
In the crisis of the financial markets of 2008-2010, the evolution of the CDS of the companies and of the countries have been continuously mentioned in the headlines of the general and specialized press. But there have always been doubts about its importance in terms of volume contracted and issued. A publication in Financial Times, indicates that the total volume issued in credit default swaps – not the daily contract, much lower – of several countries is low in relation to the total volume of public debt issued by that same country.