A credit default swap (CDS) is a type of credit derivative in which an individual or entity’s credit risk is transferred to a different individual or entity in exchange for a fee.
Credit default swaps are a type of financial instrument called a credit derivative. Read more about the different types of credit derivatives and how they can help lenders reduce their risk.
Credit default swaps are used to transfer the financial risk to a different entity in the case of default (or another credit event) and in exchange, the entity taking on the risk receives an upfront payment or recurring payments throughout the life of the loan.
Credit default swaps are the most commonly used credit derivative. They can be used for any kind of debt, but are usually used for bank loans or bonds.
Credit default swap example
Credit defaults swaps can be quite confusing to wrap your head around. Here is a simple example of a credit default swap:
Bank ABC loans Company XYZ £10,000. Bank ABC then purchases a credit default swap from a 3rd party, a hedge fund, for instance.
If Company XYZ defaults on the loan, then the hedge fund will pay the value of the loan because they took on the risk with the credit default swap.
If Company XYZ doesn’t default on the loan, then the hedge fund will keep the money that Bank ABC paid for the credit default swap.
Therefore, Bank ABC is covered by the credit default swap with the hedge fund in the case that Company XYZ defaults. The hedge fund is taking on the risk, but if Company XYZ does not default, they make a profit.
The amount paid for a CDS varies depending on how risky the loan is. If Company XYZ has a bad credit rating, then the premium that Bank ABC pays the hedge fund will be higher.
Types of credit default swaps
There are two different types of credit default swaps, based on the number of entities or assets involved in the swap. I will explain each of them below.
Single entity credit default swap
The standard single entity swap involves a credit default swap for one asset. The example above is a single entity swap because the swap only covers the one loan for Company XYZ.
Basket credit default swaps
In basket swaps, the agreement covers credit events for several entities or assets, usually at least 5. Basket swaps are generally cheaper for the buyer than swaps for each asset separately.
Banks or investors may purchase basket default swaps to cover several loans and make the process cheaper and simpler for them.
There are different agreements in the case of default or credit events with basket credit default swaps. The payment agreement may be based on the “first to default” or “second to default” within the basket of assets.
For instance, if the agreement is a second to default credit swap, payouts from the CDS seller will only happen if at least 2 of the assets in the basket default.
How is a credit default swap different from insurance?
A CDS may seem similar to an insurance policy, in which a person or entity pays a monthly or yearly premium in exchange for financial protection. However, there are a few key differences:
- In a CDS, the buyer (Bank ABC in the previous example) can obtain compensation without actually incurring a loss. With insurance, the policyholder needs to suffer a loss in order to be compensated.
- The seller (the hedge fund in the previous example) does not necessarily need to be a regulated entity.
- Insurance providers ask the buyer to report all known risks prior to accepting the agreements. This is not required with a CDS.
- If you cancel an insurance contract, the buyer generally just stops paying the premiums. With a CDS, the agreement needs to be unwound.
Credit default swap legality and risk
It is widely considered that swaps had a major impact on the 2008 financial crisis. Until 2010, credit default swaps were largely unregulated meaning that government agencies did not check to see that the seller had enough money to pay the buyer in the case of default.
Because of this, lenders agreed to riskier transactions believing that credit default swaps protected them.
Nowadays, swaps are widely used and regulated. They offer protection to lenders, as well as a steady stream of income for sellers. However, some swaps are still considered risky, especially ones without collateral.
