Credit default swap

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A credit default swap (CDS) is a contract that makes the seller of the CDS responsible for compensating the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a specified payoff amount if the loan goes bad. CDS are used to shift credit risk from the buyer to the seller.

In the event of default, the buyer of the CDS gets money, (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.[1] However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan. (A CDS unrelated to a loan is called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, the industry has agreed to a procedure to hold a credit event auction; the payment received is usually substantially less than the face value of the loan.[2] The European Parliament has approved a ban on naked CDSs, since 1 December 2011, but the ban only applies to the debt of sovereign nations.[3]

Credit default swaps have existed since the early 1990s. Their use increased after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion,[4] falling to $26.3 trillion by mid-year 2010[5] but reportedly $25.5[6] trillion in early 2012.[7]

One cause of the Recession of 2008 was that banks and insurance companies sold CDS without holding adequate reserves to protect against losses and without keeping track of the total amount of credit exposure represented by CDS contracts. As a result, the United States government bailed out the large banks and AIG, a very large insurance company.


  1. Simkovic, Michael, "Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution", Columbia Business Law Review (Vol. 2011, No. 1, pp. 118), 2011.
  2. Pollack, Lisa (January 5, 2012). Credit event auctions: Why do they exist?. FT Alphaville. Retrieved on July 9, 2012.
  3. Euro-Parliament bans "naked" Credit Default Swaps. EUbusiness (Nov 16, 2011). Retrieved on July 9, 2012.
  4. Chart; ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts, 1987-present (PDF). International Swaps and Derivatives Association (ISDA). Retrieved on April 8, 2010.
  5. ISDA 2010 MID-YEAR MARKET SURVEY. Latest available a/o 2012-03-01.
  6. ISDA: CDS Marketplace :: Market Statistics. (2010-12-31). Retrieved on July 9, 2012.
  7. Brown, Ellen (February 21, 2012). How Greece Could Take Down Wall Street. Retrieved on July 9, 2012.