Credit default swap
Credit default swap is a financial agreement whereby a seller of the CDS agrees to compensate the buyer in a situation where he defaults to repay a loan or other types of credit. The buyer makes several payment to the supplier after which he receives a payoff in the event that the payment is defaulted. In a default situation, the CDS buyer is compensation and the seller retains possession of the loan defaulted. There are situations whereby anyone is allowed to buy CDS including buyers who do not have an insured interest in the credit advance. Such CDS are known as Naked CDS.
CDS may act as credit insurance in that a bond holder may hedge against its risk of default. Investors may also buy or trade off protection if even if they may not be in possession of debt of entity in reference. The naked CDS enables dealers to guess on the credit worthiness of entity being referenced. Naked CDS constitutes the larger number of CDS in the market. CDS can also be utilized in the capital structure of a business. The reference entity is usually a government or a corporation. It should be noted that the reference person is not included in the contract. In a situation where the reference obligor defaults, the seller compensates the purchaser based on the worth of the bond in exchange for actual and tangible delivery of the bond. Settlement may be done through cash or through auction.
Credit Default Swaps were discovered in the early 1990s following trades that were conducted by bankers trust in early 1991. Later in 1994, JP Morgan Bank introduced the modern CDS. JP Morgan had extended a loan to Exxon, The bank then faced damages charges of more than the money it had extended. As a result the bank sold its credit to EBRD. The bank did this in order to improve its balance sheet. Increase in default risk increased which made regulators to have concern about and the risk was viewed as the cause of Saving & Loan crisis. They found the use of CDS to reduce default risk more appealing. In 2000, CDS became independent and was deregulated where the regulatory bodies held that CDS could not be categorized as either futures or securities.
Initially, banks formed the major players in CDS market. This was because CDS was basically used to hedge against risks of banks’ lending activities. This gave banks an opportunity to liberalize capital that was under heavy regulation. The banks eventually lost the high market share they held with credit default swaps as other asset managers noted opportunities in them. By 2002, investors dominated CDS market as speculators, unlike banks which were hedgers. The market for credit non-payment exchanges expanded greatly in from 2000 to 2007. But in 2008, it was hit by portfolio compression and the market dramatically dropped.
In 2009, there were changes that were done to oversee on the way CDS operated. This resulted into concerns of the safety of the financial instrument. The concerns followed the events of 2008 that led to decrease of CDS’ market by 38%. The European and the United States regulators are working to bring stability to derivative markets. The major changes are in two dimensions. The first one is introducing central clearing houses. The clearing houses serve as the main party existing between the buyer and the seller. This would reduce the difficulties that exist between the buyer and the seller in undertaking transactions using the instrument. The other one is the international standardization of contracts involving CDS. This would reduce legal disputes that involve determination of payout. Analysts and strategists argued that the two major changes would boost the market for CDS and enhance the environment at which transactions are conducted.
There are various criticisms about credit default swaps. The critics argue that the market of CDS has been left to expand extensively without proper regulation. They also argued that the contracts are negotiated privately hence the market lacks transparency. They also argue that the CDS market contributed largely to the 2008 financial crisis. In contrast, proponents of CDS argue that reduction of confidence causes confusion in the cause and effect and that spreads reflects that a particular user is in dire financial troubles.
Critics have also held that CDS contributed to breakdown in negotiations during reorganization of General Motors in 2009. They argued that bondholders would benefit event where the company would be declared bankrupt. They argued that the creditors of the company were pushing the company to be declared bankrupt. They add that it would be difficult to determine the writers and the buyers since transactions of the contract lacked transparency. They argued that the absence of transparency contributed to the buyers and protection writers being omitted from the negotiations. This means that credit swap risks is a financial risk that can be used to hedge against risk as well as increasing portfolio in which investors speculate in financial markets.