Credit Default Swap
A credit default swap (CDS) is a bilateral OTC derivatives contract in which the protection buyer pays periodic premiums to the protection seller in exchange for a payment contingent on a defined credit event — such as a default or bankruptcy — affecting a specified reference entity.
The credit default swap functions like an insurance policy on a bond or loan. The protection buyer pays a regular fee — expressed in basis points per year on the notional amount — to the protection seller. In return, if the reference entity (a corporation, a sovereign government, or a structured finance vehicle) experiences a defined credit event such as failure to pay, bankruptcy, restructuring, or obligation acceleration, the protection seller must compensate the buyer for the loss on the reference obligation.
Physical settlement was the original CDS settlement mechanism: upon a credit event, the protection buyer delivers the defaulted bond to the seller and receives full face value (par). Following the development of the ISDA Credit Derivatives Determinations Committee and standardized auction protocols, cash settlement became the dominant method. In a cash-settled CDS, an auction determines the recovery value of the defaulted bonds, and the protection seller pays the difference between par and recovery to the buyer.
Credit default swaps achieved notoriety during the 2007-2009 financial crisis. AIG Financial Products had sold enormous amounts of CDS protection on mortgage-backed securities and collateralized debt obligations, effectively insuring hundreds of billions of dollars of credit risk without adequate capital backing. When those reference obligations began experiencing credit events, AIG faced catastrophic margin calls that required a U.S. government rescue. The episode exposed the systemic risk of concentrated, uncollateralized CDS positions and drove the regulatory reforms of Dodd-Frank.
CDS spreads are closely watched as real-time market signals of credit health. Widening spreads on a corporate CDS indicate deteriorating market confidence in that company's ability to service its debt — often moving before credit rating agency downgrades. The CDS market provides price discovery in credit risk that the bond market alone cannot offer as efficiently.
Today, CDS on major investment-grade and high-yield corporate names, as well as sovereign CDS on government debt, trade in standardized form with central clearing through the CME and ICE Credit Clear, reducing but not eliminating the counterparty risk concerns that defined the pre-crisis era.