credit default swap

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A credit default swap (CDS) is a type of derivative contract in which two parties exchange the risk that some credit instrument will go into default. The buyer of a CDS agrees to make periodic payments to the seller. In exchange, the seller agrees to pay a lump sum to the buyer if the underlying credit instrument enters default.  

For example, imagine Bob buys $1,000,000 in Blockbuster corporate bonds. Believing that the physical movie rental business is shrinking, Bob thinks that Blockbuster might declare bankruptcy soon and be unable to pay off the bonds he bought. Therefore, Bob purchases a CDS from a bank to cover the risk that Blockbuster defaults. In exchange for monthly premiums, the bank agrees to pay off the bond in the event that Blockbuster is unable to. 

If the buyer is actually exposed to the underlying credit instrument like in the above scenario, a CDS contract functions much like insurance. If the buyer is not exposed to the underlying credit instrument, however, a CDS contract acts more like a bet against someone else’s ability to pay debts

While Credit Default Swaps can be used to mitigate risk, they also carry risk in and of themselves. A CDS protects an investor from a third-party default but opens that investor up to the risk that the CDS seller itself will default. In this scenario, a party would lose not only the income from the underlying credit instrument which went into default, but they would also lose the money they paid in premiums to the CDS seller. 

Credit default swaps played a large role in the financial crisis of 2008 for many of the same reasons described above. Large banks which traded in CDS’s were forced to declare bankruptcy when a large number of the underlying credit instruments defaulted at once, sending shockwaves throughout the United States economy. 

In response to the 2008 financial crisis, Congress passed the Dodd-Frank Act. The Dodd-Frank Act authorized the SEC and the CFTC to regulate the over-the-counter swaps market for securities, a category involving CDS's. Current SEC regulations mandate that parties participating keep stringent records and report all CDS transactions.  

[Last updated in July of 2022 by the Wex Definitions Team]