The Pros & Cons of Credit Default Swaps

The CDS market, currently perceived as the most toxic market of all, has existed for nearly 20 years. But most people have only just begun to understand what all the fuzz is about. Said as simple as possible; a CDS is a kind of  insurance a lender buys to secure oneself against a possible default by the borrower. These insurance contracts usually has a maturity period between 1 to 10 years, and usually prized as a percentage of every 10 million units (dollars, euro, yen). A new research paper shred a little more light on this rather unknown market.

“In general, CDS trading has lowered the cost of issuing bonds and enhanced the liquidity in the bond market. Nevertheless, CDS trading has also introduced a new source of risk.”

Ilhyock Shimy/Haibin Zhu


According to the two researchers employed by the Monetary and Economic Department of the Bank for International Settlements, CDS trading has lowered the cost of issuing bonds and enhanced the liquidity in the bond market. The positive impact is stronger for smaller firms, non-…nancial …rms and those fi…rms with higher liquidity in the CDS market, while the negative is that companies included in CDS indices must face higher bond yield spreads than those not included.

The rise and fall of the credit derivatives market is considered the single most important event in the global credit market in the past decade.

Even thou it has existed for nearly 20 years, no one has paid much attention to it.

Until it blew up like an Icelandic volcano in 2008 and covered the whole world with a black cloud of hidden financial risks, that is.

By then the credit derivative market had swollen up to a huge, unmeasurable, uncontrollable market, with an estimated value of more than 60 trillion dollar. Credit-default swaps is one of the most traded credit derivatives, making up almost 90% of the totals.

According to the new research, the notional value of this market have been cut in half since the peak in 2008.

A Short Lesson

By the way – to compare a CDS with a credit insurances is not quite accurate:

A (CDS) is a swap contract and agreement in which the protection buyer of the CDS makes a series of payments (referred to as the spread) to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event. In fact, it’s a form of reverse trading.

The simplest credit-default swap is a bilateral contract between the buyer and seller of protection. The CDS will refer to a “reference entity” or “reference obligor”, usually a corporation or government.

The reference entity is not a party to the contract. The protection buyer makes quarterly premium payments—the spread —to the protection seller.

If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction.

A default is referred to as a “credit event” and include such events as failure to pay, restructuring and bankruptcy.

So, with that out-of-the-way, I’ll go on.

A Double-Edge Sword

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The CDS contracts have been perceived as the main root of all evil in the credit market because of its complex distribution of risk.

The new research paper by Ilhyock Shimy and Haibin Zhu do not confirm, nor dismiss the allegation.

They point, however, to the fact that the CDS market have both positive and negative impact on the financial markets in general.

This is their main findings:

“First, we …find strong evidence that CDS trading is associated with lower cost and higher liquidity for new bond issuance in Asia. This is consistent with the hypothesis that CDS trading helps create new hedging opportunities and improve information transparency for investors. Noticeably, this result is contrary to similar studies based on US data. This contrast provides supporting evidence for our conjecture on the jump-start e¤ect in Asia.

“Second, we …find that the positive impact of CDS trading on the bond market tends to be more remarkable for smaller fi…rms and non-f…nancial …firms. In addition, those …rms with higher liquidity in the CDS market bene…t more in the primary bond market in terms of cost and liquidity.”
“Last, we also …nd that the impact of CDS trading on the bond market is di¤erent during the crisis period. The global …nancial crisis that occurred during the sample period o¤ers a good case study to examine the behaviour of the CDS and bond markets under distress and their linkages. Our analysis shows that, at the peak of the global …nancial crisis, those firms included in CDS indices had to face higher spreads than those not included in CDS indices, above and beyond the general increase in credit spreads observed in the bond market during this period. This suggests that CDS trading could be a double-edged sword: it also introduces new sources of shocks to the bond market.”

Here’s a copy of the full report.

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