A credit default swap (CDS) is a derivative contract that transfers credit risk in return for a series of payments. It allows a bond holder to buy insurance against default risk. Like a cat bond, a CDS is not, legally, an insurance contract, which is important for reasons explained below.
Buying a credit default swap does not eliminate all the risks associated with holding debt: interest rate risk, in particular, remains with the holder.
A CDS can also be seen as away of decomposing the yield on a bond into the risk premium (which the insurer receives) and the risk free rate — although this is complicated by the addition of counter party risk.
Credit default swaps differ from insurance proper (for example, credit risk insurance from monoline insurers) in a a number of ways:
- Protection sellers are not necessarily insurers and are not regulated as such (although most are banks and are therefore not unregulated)
- As a result, they are not required to keep reserves against the risk
- Buyers do not need to act uberrimae fides
- Buyers do not need an insurable interest
The last of these has important consequences. Insurance (other than life assurance)legally requires that the buyer has an insurable interest: that they would suffer a financial loss of the event insured against occurs.
Because credit default swaps are not insurance, the protection buyer may not actually own the bond that the CDS is based on (“references”). The buyer may be speculating, or hedging a different exposure to the issuer of the bond, or even another risk that is correlated with it (e.g. a creditor in the same country and industry sector).
The consequences of the differences in regulation and the caveat emptor basis of the contracts should be obvious.
The seller of protection in a credit default swap is in a similar position to the writer of an option. If there is no default on the underlying, then the seller makes money. If there is a default the seller has to cover it. Because the payments are not all made upfront, the seller is also exposed to counter-party risk.