Credit default swap

A credit default swap (CDS) is a financial swap

agreement that the seller of the CDS will compensate
the buyer in the event of a debt default (by the debtor)
or other credit event.[1] That is, the seller of the CDS
insures the buyer against some reference asset
defaulting. The buyer of the CDS makes a series of
payments (the CDS "fee" or "spread") to the seller
and, in exchange, may expect to receive a payoff if the
asset defaults.

In the event of default, the buyer of the credit default

swap receives compensation (usually the face value of
the loan), and the seller of the CDS takes possession of
the defaulted loan or its market value in cash. If the reference bond performs without default, the
However, anyone can purchase a CDS, even buyers protection buyer pays quarterly payments to the
who do not hold the loan instrument and who have no seller until maturity
direct insurable interest in the loan (these are called
"naked" CDSs). If there are more CDS contracts
outstanding than bonds in existence, a protocol exists
to hold a credit event auction. The payment received is
often substantially less than the face value of the
loan.[2]

Credit default swaps in their current form have existed

since the early 1990s and increased in use in the early
2000s. By the end of 2007, the outstanding CDS
amount was $62.2 trillion,[3] falling to $26.3 trillion by
mid-year 2010[4] and reportedly $25.5[5] trillion in
early 2012. CDSs are not traded on an exchange and
there is no required reporting of transactions to a
If the reference bond defaults, the protection seller
government agency.[6] During the 2007–2010
pays par value of the bond to the buyer, and the
financial crisis the lack of transparency in this large
buyer transfers ownership of the bond to the seller
market became a concern to regulators as it could pose
a systemic risk.[7][8][9] In March 2010, the Depository
Trust & Clearing Corporation (see Sources of Market Data) announced it would give regulators greater
access to its credit default swaps database.[10] There is "$8 trillion notional value outstanding" as of June
2018.[11]

CDS data can be used by financial professionals,[12] regulators, and the media to monitor how the market
views credit risk of any entity on which a CDS is available, which can be compared to that provided by the
Credit Rating Agencies.

Most CDSs are documented using standard forms drafted by the International Swaps and Derivatives
Association (ISDA), although there are many variants.[7] In addition to the basic, single-name swaps, there
are basket default swaps (BDSs), index CDSs, funded CDSs (also called credit-linked notes), as well as
loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity
can include a special purpose vehicle issuing asset-backed securities.[12][13]

Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in
bankruptcy with a lack of transparency. A CDS can be unsecured (without collateral) and be at higher risk
for a default.

Description
A CDS is linked to a "reference entity" or "reference obligor", usually a
corporation or government. The reference entity is not a party to the
contract. The buyer makes regular premium payments to the seller, the
premium amounts constituting the "spread" charged in basis points by the
seller to insure against a credit event. 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.[7][14] Buyer purchased a CDS at
time t0 and makes regular
A default is often referred to as a "credit event" and includes such events premium payments at times
as failure to pay, restructuring and bankruptcy, or even a drop in the t1, t2, t3, and t4. If the
borrower's credit rating.[7] CDS contracts on sovereign obligations also associated credit instrument
usually include as credit events repudiation, moratorium, and suffers no credit event, then
the buyer continues paying
acceleration.[6] Most CDSs are in the $10–$20 million range[15] with
premiums at t5, t6 and so on
maturities between one and 10 years. Five years is the most typical
until the end of the contract at
maturity.[12][13]
time tn.
An investor or speculator may "buy protection" to hedge the risk of
default on a bond or other debt instrument, regardless of whether such
investor or speculator holds an interest in or bears any risk of loss relating
to such bond or debt instrument. In this way, a CDS is similar to credit
insurance, although CDSs are not subject to regulations governing
traditional insurance. Also, investors can buy and sell protection without
owning debt of the reference entity. These "naked credit default swaps"
However, if the associated
allow traders to speculate on the creditworthiness of reference entities.
credit instrument suffered a
CDSs can be used to create synthetic long and short positions in the
credit event at t5, then the
reference entity.[8] Naked CDS constitute most of the market in
seller pays the buyer for the
CDS.[16][17] In addition, CDSs can also be used in capital structure loss, and the buyer would
arbitrage. cease paying premiums to the
seller.
A "credit default swap" (CDS) is a credit derivative contract between
two counterparties. The buyer makes periodic payments to the seller, and
in return receives a payoff if an underlying financial instrument defaults
or experiences a similar credit event.[7][14][18] The CDS may refer to a specified loan or bond obligation of
a "reference entity", usually a corporation or government.[15]

As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky
Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of
protection. If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank,
and the CDS contract is terminated.
If the investor actually owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a
hedge. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any
Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a
gamble to make money, or to hedge investments in other companies whose fortunes are expected to be
similar to those of Risky Corp (see Uses).

If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur:

the investor delivers a defaulted asset to Bank for payment of the par value, which is known
as physical settlement;
AAA-Bank pays the investor the difference between the par value and the market price of a
specified debt obligation (even if Risky Corp defaults there is usually some recovery, i.e., not
all the investor's money is lost), which is known as cash settlement.

The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the
length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of
Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth
of protection from AAA-Bank must pay the bank $50,000. Payments are usually made on a quarterly basis,
in arrears. These payments continue until either the CDS contract expires or Risky Corp defaults.

All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the
CDS associated with a company with a higher CDS spread is considered more likely to default by the
market, since a higher fee is being charged to protect against this happening. However, factors such as
liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of
the underlying or reference obligations are considered among money managers to be the best indicators of
the likelihood of sellers of CDSs having to perform under these contracts.[7]

Differences from insurance

CDS contracts have obvious similarities with insurance contracts because the buyer pays a premium and, in
return, receives a sum of money if an adverse event occurs.

However, there are also many differences, the most important being that an insurance contract provides an
indemnity against the losses actually suffered by the policy holder on an asset in which it holds an insurable
interest. By contrast, a CDS provides an equal payout to all holders, calculated using an agreed, market-
wide method. The holder does not need to own the underlying security and does not even have to suffer a
loss from the default event.[19][20][21][22] The CDS can therefore be used to speculate on debt objects.

The other differences include:

The seller might in principle not be a regulated entity (though in practice most are banks);
The seller is not required to maintain reserves to cover the protection sold (this was a
principal cause of AIG's financial distress in 2008; it had insufficient reserves to meet the
"run" of expected payouts caused by the collapse of the housing bubble);
Insurance requires the buyer to disclose all known risks, while CDSs do not (the CDS seller
can in many cases still determine potential risk, as the debt instrument being "insured" is a
market commodity available for inspection, but in the case of certain instruments like CDOs
made up of "slices" of debt packages, it can be difficult to tell exactly what is being insured);
Insurers manage risk primarily by setting loss reserves based on the Law of large numbers
and actuarial analysis. Dealers in CDSs manage risk primarily by means of hedging with
other CDS deals and in the underlying bond markets;
 CDS contracts are generally subject to mark-to-market accounting, introducing income
statement and balance sheet volatility while insurance contracts are not;
Hedge accounting may not be available under US Generally Accepted Accounting
Principles (GAAP) unless the requirements of FAS 133 (https://web.archive.org/web/200205
02130101/http://www.fasb.org/st/summary/stsum133.shtml) are met. In practice this rarely
happens;
To cancel the insurance contract, the buyer can typically stop paying premiums, while for
CDS the contract needs to be unwound.

Risk

When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk:[7][13][23]

The buyer takes the risk that the seller may default. If AAA-Bank and Risky Corp. default
simultaneously ("double default"), the buyer loses its protection against default by the
reference entity. If AAA-Bank defaults but Risky Corp. does not, the buyer might need to
replace the defaulted CDS at a higher cost.
The seller takes the risk that the buyer may default on the contract, depriving the seller of the
expected revenue stream. More importantly, a seller normally limits its risk by buying
offsetting protection from another party — that is, it hedges its exposure. If the original buyer
drops out, the seller squares its position by either unwinding the hedge transaction or by
selling a new CDS to a third party. Depending on market conditions, that may be at a lower
price than the original CDS and may therefore involve a loss to the seller.

In the future, in the event that regulatory reforms require that CDS be traded and settled via a central
exchange/clearing house, such as ICE TCC, there will no longer be "counterparty risk", as the risk of the
counterparty will be held with the central exchange/clearing house.

As is true with other forms of over-the-counter derivatives, CDS might involve liquidity risk. If one or both
parties to a CDS contract must post collateral (which is common), there can be margin calls requiring the
posting of additional collateral. The required collateral is agreed on by the parties when the CDS is first
issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS
contract changes, or the credit rating of one of the parties changes. Many CDS contracts even require
payment of an upfront fee (composed of "reset to par" and an "initial coupon.").[24]

Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk.[7] A seller of a
CDS could be collecting monthly premiums with little expectation that the reference entity may default. A
default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to
protection buyers.[25] This risk is not present in other over-the-counter derivatives.[7][25]

Sources of market data

Data about the credit default swaps market is available from three main sources. Data on an annual and
semiannual basis is available from the International Swaps and Derivatives Association (ISDA) since
2001[26] and from the Bank for International Settlements (BIS) since 2004.[27] The Depository Trust &
Clearing Corporation (DTCC), through its global repository Trade Information Warehouse (TIW), provides
weekly data but publicly available information goes back only one year.[28] The numbers provided by each
source do not always match because each provider uses different sampling methods.[7] Daily, intraday and
real time data is available from S&P Capital IQ through their acquisition of Credit Market Analysis in
2012.[29]
According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for
virtually all CDS contracts outstanding in the marketplace."[30]

The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S
commercial banks and trust companies.[31]

Uses
Credit default swaps can be used by investors for speculation, hedging and arbitrage.

Speculation

Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market
indices such as the North American CDX index or the European iTraxx index. An investor might believe
that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit
from that view by entering into a trade, known as a basis trade, that combines a CDS with a cash bond and
an interest rate swap.

Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads increase as
credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy
CDS protection on a company to speculate that it is about to default. Alternatively, the investor might sell
protection if it thinks that the company's creditworthiness might improve. The investor selling the CDS is
viewed as being "long" on the CDS and the credit, as if the investor owned the bond.[8][13] In contrast, the
investor who bought protection is "short" on the CDS and the underlying credit.[8][13]

Credit default swaps opened up important new avenues to speculators. Investors could go long on a bond
without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of
default.[32] Shorting a bond faced difficult practical problems, such that shorting was often not feasible;
CDS made shorting credit possible and popular.[13][32] Because the speculator in either case does not own
the bond, its position is said to be a synthetic long or short position.[8]

For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys
$10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference
entity, at a spread of 500 basis points (=5%) per annum.

If Risky Corp does indeed default after, say, one year, then the hedge fund will have paid
$500,000 to AAA-Bank, but then receives $10 million (assuming zero recovery rate, and that
AAA-Bank has the liquidity to cover the loss), thereby making a profit. AAA-Bank, and its
investors, will incur a $9.5 million loss minus recovery unless the bank has somehow offset
the position before the default.
However, if Risky Corp does not default, then the CDS contract runs for two years, and the
hedge fund ends up paying $1 million, without any return, thereby making a loss. AAA-Bank,
by selling protection, has made $1 million without any upfront investment.

Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its
position after a certain period of time in an attempt to realise its gains or losses. For example:

After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread
has widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million
worth of protection for 1 year to AAA-Bank at this higher rate. Therefore, over the two years
 the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but receives 1 * 15% *
$10 million = $1.5 million, giving a total profit of $500,000.
In another scenario, after one year the market now considers Risky much less likely to
default, so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge fund
may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this lower
spread. Therefore, over the two years the hedge fund pays the bank 2 * 5% * $10 million =
$1 million, but receives 1 * 2.5% * $10 million = $250,000, giving a total loss of $750,000.
This loss is smaller than the $1 million loss that would have occurred if the second
transaction had not been entered into.

Transactions such as these do not even have to be entered into over the long-term. If Risky Corp's CDS
spread had widened by just a couple of basis points over the course of one day, the hedge fund could have
entered into an offsetting contract immediately and made a small profit over the life of the two CDS
contracts.

Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of
owning bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without
owning those assets through the use of CDS.[9] CDOs are viewed as complex and opaque financial
instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is the subject of the civil suit for
fraud brought by the SEC against Goldman Sachs in April 2010.[33] Abacus is a synthetic CDO consisting
of credit default swaps referencing a variety of mortgage-backed securities.

Naked credit default swaps

In the examples above, the hedge fund did not own any debt of Risky Corp. A CDS in which the buyer
does not own the underlying debt is referred to as a naked credit default swap, estimated to be up to 80% of
the credit default swap market.[16][17] There is currently a debate in the United States and Europe about
whether speculative uses of credit default swaps should be banned. Legislation is under consideration by
Congress as part of financial reform.[17]

Critics assert that naked CDSs should be banned, comparing them to buying fire insurance on your
neighbor's house, which creates a huge incentive for arson. Analogizing to the concept of insurable interest,
critics say you should not be able to buy a CDS—insurance against default—when you do not own the
bond.[34][35][36] Short selling is also viewed as gambling and the CDS market as a casino.[17][37] Another
concern is the size of the CDS market. Because naked credit default swaps are synthetic, there is no limit to
how many can be sold. The gross amount of CDSs far exceeds all "real" corporate bonds and loans
outstanding.[6][35] As a result, the risk of default is magnified leading to concerns about systemic risk.[35]

Financier George Soros called for an outright ban on naked credit default swaps, viewing them as "toxic"
and allowing speculators to bet against and "bear raid" companies or countries.[38] His concerns were
echoed by several European politicians who, during the Greek Financial Crisis, accused naked CDS buyers
of making the crisis worse.[39][40]

Despite these concerns, former United States Secretary of the Treasury Geithner[17][39] and Commodity
Futures Trading Commission Chairman Gensler[41] are not in favor of an outright ban on naked credit
default swaps. They prefer greater transparency and better capitalization requirements.[17][25] These
officials think that naked CDSs have a place in the market.

Proponents of naked credit default swaps say that short selling in various forms, whether credit default
swaps, options or futures, has the beneficial effect of increasing liquidity in the marketplace.[34] That
benefits hedging activities. Without speculators buying and selling naked CDSs, banks wanting to hedge
might not find a ready seller of protection.[17][34] Speculators also create a more competitive marketplace,
keeping prices down for hedgers. A robust market in credit default swaps can also serve as a barometer to
regulators and investors about the credit health of a company or country.[34][42]

Germany's market regulator BaFin found that naked CDS did not worsen the Greek credit crisis.[40] Some
suggest that without credit default swaps, Greece's borrowing costs would be higher.[40] As of November
2011, the Greek bonds have a bond yield of 28%.[43]

A bill in the U.S. Congress proposed giving a public authority the power to limit the use of CDSs other
than for hedging purposes, but the bill did not become law.[44]

Hedging

Credit default swaps are often used to manage the risk of default that arises from holding debt. A bank, for
example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the
buyer of protection. If the loan goes into default, the proceeds from the CDS contract cancel out the losses
on the underlying debt.[15]

There are other ways to eliminate or reduce the risk of default. The bank could sell (that is, assign) the loan
outright or bring in other banks as participants. However, these options may not meet the bank's needs.
Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to
find loan participants.[9]

If both the borrower and lender are well-known and the market (or even worse, the news media) learns that
the bank is selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which
could severely damage the banker-client relationship. In addition, the bank simply may not want to sell or
share the potential profits from the loan. By buying a credit default swap, the bank can lay off default risk
while still keeping the loan in its portfolio.[9] The downside to this hedge is that without default risk, a bank
may have no motivation to actively monitor the loan and the counterparty has no relationship to the
borrower.[9]

Another kind of hedge is against concentration risk. A bank's risk management team may advise that the
bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this risk
by buying a CDS. Because the borrower—the reference entity—is not a party to a credit default swap,
entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio
or customer relations.[7] Similarly, a bank selling a CDS can diversify its portfolio by gaining exposure to
an industry in which the selling bank has no customer base.[13][15][45]

A bank buying protection can also use a CDS to free regulatory capital. By offloading a particular credit
risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8% of
the total loan under Basel I). This frees resources the bank can use to make other loans to the same key
customer or to other borrowers.[7][46]

Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds
or insurance companies, may buy a CDS as a hedge for similar reasons. Pension fund example: A pension
fund owns five-year bonds issued by Risky Corp with par value of $10 million. To manage the risk of
losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a
notional amount of $10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In
return for this credit protection, the pension fund pays 2% of $10 million ($200,000) per annum in quarterly
installments of $50,000 to Derivative Bank.
 If Risky Corporation does not default on its bond payments, the pension fund makes
quarterly payments to Derivative Bank for 5 years and receives its $10 million back after five
years from Risky Corp. Though the protection payments totaling $1 million reduce
investment returns for the pension fund, its risk of loss due to Risky Corp defaulting on the
bond is eliminated.
If Risky Corporation defaults on its debt three years into the CDS contract, the pension fund
would stop paying the quarterly premium, and Derivative Bank would ensure that the
pension fund is refunded for its loss of $10 million minus recovery (either by physical or cash
settlement — see Settlement below). The pension fund still loses the $600,000 it has paid
over three years, but without the CDS contract it would have lost the entire $10 million minus
recovery.

In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a
basket of similar risks as a proxy for its own credit risk exposure on receivables.[17][34][46][47]

Although credit default swaps have been highly criticized for their role in the recent financial crisis, most
observers conclude that using credit default swaps as a hedging device has a useful purpose.[34]

Arbitrage

Capital Structure Arbitrage is an example of an arbitrage strategy that uses CDS transactions.[48] This
technique relies on the fact that a company's stock price and its CDS spread should exhibit negative
correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread
should tighten, since it is less likely to default on its debt. However, if its outlook worsens then its CDS
spread should widen and its stock price should fall.

Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies
between different parts of the same company's capital structure; i.e., mis-pricings between a company's debt
and equity. An arbitrageur attempts to exploit the spread between a company's CDS and its equity in certain
situations.

For example, if a company has announced some bad news and its share price has dropped by 25%, but its
CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to
the share price. Therefore, a basic strategy would be to go long on the CDS spread (by buying CDS
protection) while simultaneously hedging oneself by buying the underlying stock. This technique would
benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the
company's CDS spread tightened relative to its equity.

An interesting situation in which the inverse correlation between a company's stock price and CDS spread
breaks down is during a Leveraged buyout (LBO). Frequently this leads to the company's CDS spread
widening due to the extra debt that will soon be put on the company's books, but also an increase in its
share price, since buyers of a company usually end up paying a premium.

Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should
trade closely with that of the underlying cash bond issued by the reference entity. Misalignment in spreads
may occur due to technical reasons such as:

Specific settlement differences

Shortages in a particular underlying instrument
The cost of funding a position
Existence of buyers constrained from buying exotic derivatives.
The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be
close to zero. Basis trades attempt to exploit this difference to make a profit, however hedging a bond with
a CDS does have irreducible risks which should be considered when making basis trades.[49]

History

Conception

Forms of credit default swaps had been in existence from at least the early 1990s,[50] with early trades
carried out by Bankers Trust in 1991.[51] J.P. Morgan & Co. and economist Blythe Masters are widely
credited with creating the modern credit default swap in 1994.[52][53][54] In that instance, J.P. Morgan had
extended a $4.8 billion credit line to Exxon, which faced the threat of $5 billion in punitive damages for the
Exxon Valdez oil spill. A team of J.P. Morgan bankers led by Masters then sold the credit risk from the
credit line to the European Bank of Reconstruction and Development in order to cut the reserves that J.P.
Morgan was required to hold against Exxon's default, thus improving its own balance sheet.[53]

Despite early successes, credit default swaps could not be profitable until an industrialized and streamlined
process was created to issue them. This changed when CDS's began to be traded as securities from
JPMorgan, an effort led by Bill Demchak where he and his team created bundles of swaps and sold them to
investors. The investors would get the streams of revenue, according to the risk-and-reward level they
chose; the bank would get insurance against its loans, and fees for setting up the deal.[53]

In 1997, JPMorgan developed a proprietary product called BISTRO (Broad Index Securitized Trust
Offering) that used CDS to clean up a bank's balance sheet.[52][54] The advantage of BISTRO was that it
used securitization to split up the credit risk into little pieces that smaller investors found more digestible,
since most investors lacked EBRD's capability to accept $4.8 billion in credit risk all at once. BISTRO was
the first example of what later became known as synthetic collateralized debt obligations (CDOs). There
were two Bistros in 1997 for approximately $10 billion (~$15.9 billion in 2021) each.[55]

Mindful of the concentration of default risk as one of the causes of the S&L crisis, regulators initially found
CDS's ability to disperse default risk attractive.[51] In 2000, credit default swaps became largely exempt
from regulation by both the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures
Trading Commission (CFTC). The Commodity Futures Modernization Act of 2000, which was also
responsible for the Enron loophole,[6] specifically stated that CDSs are neither futures nor securities and so
are outside the remit of the SEC and CFTC.[51]

Market growth

At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in
connection with their lending activities. Banks also saw an opportunity to free up regulatory capital. By
March 1998, the global market for CDS was estimated at $300 billion, with JP Morgan alone accounting
for about $50 billion of this.[51]

The high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge
funds saw trading opportunities in credit default swaps. By 2002, investors as speculators, rather than banks
as hedgers, dominated the market.[7][13][46][50] National banks in the USA used credit default swaps as
early as 1996.[45] In that year, the Office of the Comptroller of the Currency measured the size of the
market as tens of billions of dollars.[56] Six years later, by year-end 2002, the outstanding amount was over
$2 trillion (~$2.92 trillion in 2021).[3]
Although speculators fueled the exponential growth, other factors also played a part. An extended market
could not emerge until 1999, when ISDA standardized the documentation for credit default
swaps.[57][58][59] Also, the 1997 Asian Financial Crisis spurred a market for CDS in emerging market
sovereign debt.[59] In addition, in 2004, index trading began on a large scale and grew rapidly.[13]

The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003.[3]
By the end of 2007, the CDS market had a notional value of $62.2 trillion.[3] But notional amount fell
during 2008 as a result of dealer "portfolio compression" efforts (replacing offsetting redundant contracts),
and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion.[60]

Explosive growth was not without operational headaches. On September 15, 2005, the New York Fed
summoned 14 banks to its offices. Billions of dollars of CDS were traded daily but the record keeping was
more than two weeks behind.[61] This created severe risk management issues, as counterparties were in
legal and financial limbo.[13][62] U.K. authorities expressed the same concerns.[63]

Market as of 2008

Since default is a relatively rare occurrence (historically around

0.2% of investment grade companies default in any one year),[64]
in most CDS contracts the only payments are the premium
payments from buyer to seller. Thus, although the above figures for
outstanding notionals are very large, in the absence of default the
net cash flows are only a small fraction of this total: for a 100 bp =
1% spread, the annual cash flows are only 1% of the notional
amount.

Regulatory concerns over CDS

Composition of the United States
15.5 trillion US dollar CDS market at
The market for Credit Default Swaps attracted considerable
the end of 2008 Q2. Green tints
concern from regulators after a number of large scale incidents in show Prime asset CDSs, reddish
2008, starting with the collapse of Bear Stearns.[65] tints show sub-prime asset CDSs.
Numbers followed by "Y" indicate
In the days and weeks leading up to Bear's collapse, the bank's
years until maturity.
CDS spread widened dramatically, indicating a surge of buyers
taking out protection on the bank. It has been suggested that this
widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its
access to wholesale capital, which eventually led to its forced sale to JP Morgan in March. An alternative
view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear's collapse; i.e.,
investors saw that Bear was in trouble, and sought to hedge any naked exposure to the bank, or speculate
on its collapse.

In September, the bankruptcy of Lehman Brothers caused a total close to $400 billion to become payable to
the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed
hands was around $7.2 billion.[66] This difference is due to the process of 'netting'. Market participants co-
operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them
from their hedging positions. Dealers generally attempt to remain risk-neutral, so that their losses and gains
after big events offset each other.
Also in September American International Group (AIG) required
[67] an $85 billion federal loan because it had been excessively

selling CDS protection without hedging against the possibility that

the reference entities might decline in value, which exposed the
insurance giant to potential losses over $100 billion. The CDS on
Lehman were settled smoothly, as was largely the case for the other
11 credit events occurring in 2008 that triggered payouts.[65] And
while it is arguable that other incidents would have been as bad or
worse if less efficient instruments than CDS had been used for
speculation and insurance purposes, the closing months of 2008
saw regulators working hard to reduce the risk involved in CDS
transactions. Proportion of CDSs nominals (lower
left) held by United States banks
In 2008 there was no centralized exchange or clearing house for compared to all derivatives, in
CDS transactions; they were all done over the counter (OTC). This 2008Q2. The black disc represents
led to recent calls for the market to open up in terms of the 2008 public debt.
transparency and regulation.[68]

In November 2008 the Depository Trust & Clearing Corporation (DTCC), which runs a warehouse for
CDS trade confirmations accounting for around 90% of the total market,[69] announced that it will release
market data on the outstanding notional of CDS trades on a weekly basis.[70] The data can be accessed on
the DTCC's website here:[71]

By 2010, Intercontinental Exchange, through its subsidiaries, ICE Trust in New York, launched in 2008,
and ICE Clear Europe Limited in London, UK, launched in July 2009, clearing entities for credit default
swaps (CDS) had cleared more than $10 trillion in credit default swaps (CDS) (Terhune Bloomberg
Business Week 2010-07-29).[72][notes 1] Bloomberg's Terhune (2010) explained how investors seeking
high-margin returns use Credit Default Swaps (CDS) to bet against financial instruments owned by other
companies and countries. Intercontinental's clearing houses guarantee every transaction between buyer and
seller providing a much-needed safety net reducing the impact of a default by spreading the risk. ICE
collects on every trade.(Terhune Bloomberg Business Week 2010-07-29).[72] Brookings senior research
fellow, Robert E. Litan, cautioned however, "valuable pricing data will not be fully reported, leaving ICE's
institutional partners with a huge informational advantage over other traders. He calls ICE Trust "a
derivatives dealers' club" in which members make money at the expense of nonmembers (Terhune citing
Litan in Bloomberg Business Week 2010-07-29).[72] (Litan Derivatives Dealers’ Club 2010)." [73] Actually,
Litan conceded that "some limited progress toward central clearing of CDS has been made in recent
months, with CDS contracts between dealers now being cleared centrally primarily through one
clearinghouse (ICE Trust) in which the dealers have a significant financial interest (Litan 2010:6)."[73]
However, "as long as ICE Trust has a monopoly in clearing, watch for the dealers to limit the expansion of
the products that are centrally cleared, and to create barriers to electronic trading and smaller dealers making
competitive markets in cleared products (Litan 2010:8)."[73]

In 2009 the U.S. Securities and Exchange Commission granted an exemption for Intercontinental
Exchange to begin guaranteeing credit-default swaps. The SEC exemption represented the last regulatory
approval needed by Atlanta-based Intercontinental.[74] A derivatives analyst at Morgan Stanley, one of the
backers for IntercontinentalExchange's subsidiary, ICE Trust in New York, launched in 2008, claimed that
the "clearinghouse, and changes to the contracts to standardize them, will probably boost activity".[74]
IntercontinentalExchange's subsidiary, ICE Trust's larger competitor, CME Group Inc., hasn't received an
SEC exemption, and agency spokesman John Nester said he didn't know when a decision would be made.

Market as of 2009

The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from
concerns over the instruments' safety after the events of the previous year. According to Deutsche Bank
managing director Athanassios Diplas "the industry pushed through 10 years worth of changes in just a few
months". By late 2008 processes had been introduced allowing CDSs that offset each other to be cancelled.
Along with termination of contracts that have recently paid out such as those based on Lehmans, this had
by March reduced the face value of the market down to an estimated $30 trillion.[75]

The Bank for International Settlements estimates that outstanding derivatives total $708 trillion.[76] U.S.
and European regulators are developing separate plans to stabilize the derivatives market. Additionally there
are some globally agreed standards falling into place in March 2009, administered by International Swaps
and Derivatives Association (ISDA). Two of the key changes are:

1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as
the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both
buyer and seller face.

2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where
what the payout should be is unclear.

Speaking before the changes went live, Sivan Mahadevan, a derivatives analyst at Morgan Stanley,[74] one
of the backers for IntercontinentalExchange's subsidiary, ICE Trust in New York, launched in 2008,
claimed that

A clearinghouse, and changes to the contracts to standardize them, will probably boost activity.
... Trading will be much easier.... We'll see new players come to the market because they’ll like
the idea of this being a better and more traded product. We also feel like over time we'll see the
creation of different types of products (Mahadevan cited in Bloomberg 2009).

In the U.S., central clearing operations began in March 2009, operated by InterContinental Exchange
(ICE). A key competitor also interested in entering the CDS clearing sector is CME Group.

In Europe, CDS Index clearing was launched by IntercontinentalExchange's European subsidiary ICE
Clear Europe on July 31, 2009. It launched Single Name clearing in Dec 2009. By the end of 2009, it had
cleared CDS contracts worth EUR 885 billion reducing the open interest down to EUR 75 billion[77]

By the end of 2009, banks had reclaimed much of their market share; hedge funds had largely retreated
from the market after the crises. According to an estimate by the Banque de France, by late 2009 the bank
JP Morgan alone now had about 30% of the global CDS market.[51][77]

Government approvals relating to ICE and its competitor CME

The SEC's approval for ICE Futures' request to be exempted from rules that would prevent it clearing
CDSs was the third government action granted to Intercontinental in one week. On March 3, its proposed
acquisition of Clearing Corp., a Chicago clearinghouse owned by eight of the largest dealers in the credit-
default swap market, was approved by the Federal Trade Commission and the Justice Department. On
March 5, 2009, the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to
begin clearing.

Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG,
received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s cash on
hand and a 50–50 profit-sharing agreement with Intercontinental on the revenue generated from processing
the swaps.

SEC spokesperson John Nestor stated

For several months the SEC and our fellow regulators have worked closely with all of the
firms wishing to establish central counterparties.... We believe that CME should be in a
position soon to provide us with the information necessary to allow the commission to take
action on its exemptive requests.

Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and
LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan.
30, no swaps had been cleared by the NYSE’s London- based derivatives exchange, according to NYSE
Chief Executive Officer Duncan Niederauer.[78]

Clearing house member requirements

Members of the Intercontinental clearinghouse ICE Trust (now ICE Clear Credit) in March 2009 would
have to have a net worth of at least $5 billion (~$6.23 billion in 2021) and a credit rating of A or better to
clear their credit-default swap trades. Intercontinental said in the statement today that all market participants
such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long
as they meet these requirements.

A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of counterparty
defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded,
participants are exposed to each other in case of a default. A clearinghouse also provides one location for
regulators to view traders’ positions and prices.

J.P. Morgan losses

In April 2012, hedge fund insiders became aware that the market in credit default swaps was possibly being
affected by the activities of Bruno Iksil, a trader at J.P. Morgan Chief Investment Office (CIO), referred to
as "the London whale" in reference to the huge positions he was taking. Heavy opposing bets to his
positions are known to have been made by traders, including another branch of J.P. Morgan, who
purchased the derivatives offered by J.P. Morgan in such high volume.[79][80] Major losses, $2 billion
(~$2.37 billion in 2021), were reported by the firm in May 2012 in relationship to these trades. The
disclosure, which resulted in headlines in the media, did not disclose the exact nature of the trading
involved, which remains in progress. The item traded, possibly related to CDX IG 9, an index based on the
default risk of major U.S. corporations,[81][82] has been described as a "derivative of a derivative".[83][84]

Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions
as published by the International Swaps and Derivatives Association.[85] The confirmation typically
specifies a reference entity, a corporation or sovereign that generally, although not always, has debt
outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond.
The period over which default protection extends is defined by the contract effective date and scheduled
termination date.

The confirmation also specifies a calculation agent who is responsible for making determinations as to
successors and substitute reference obligations (for example necessary if the original reference obligation
was a loan that is repaid before the expiry of the contract), and for performing various calculation and
administrative functions in connection with the transaction. By market convention, in contracts between
CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS
dealers, the protection seller is generally the calculation agent.

It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred
but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly
available information delivered along with a credit event notice. Typical CDS contracts do not provide an
internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the
matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection
seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with
respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt.
CDS written on North American investment grade corporate reference entities, European corporate
reference entities and sovereigns generally also include restructuring as a credit event, whereas trades
referencing North American high-yield corporate reference entities typically do not.

Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of
obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable
obligation characteristics vary for different markets and CDS contract types. Typical limitations include that
deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated,
that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that
it not be subject to some contingency before becoming due.

The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates)
falling on March 20, June 20, September 20, and December 20. Due to the proximity to the IMM dates,
which fall on the third Wednesday of these months, these CDS maturity dates are also referred to as "IMM
dates".

Credit default swap and sovereign debt crisis

The European sovereign debt crisis resulted from a combination of complex factors, including the
globalisation of finance; easy credit conditions during the 2002–2008 period that encouraged high-risk
lending and borrowing practices; the 2007–2012 global financial crisis; international trade imbalances; real-
estate bubbles that have since burst; the 2008–2012 global recession; fiscal policy choices related to
government revenues and expenses; and approaches used by nations to bail out troubled banking industries
and private bondholders, assuming private debt burdens or socialising losses. The Credit default swap
market also reveals the beginning of the sovereign crisis.

Since December 1, 2011 the European Parliament has banned naked Credit default swap (CDS) on the
debt for sovereign nations.[86]
The definition of restructuring is quite technical but is
essentially intended to respond to circumstances where
a reference entity, as a result of the deterioration of its
credit, negotiates changes in the terms in its debt with
its creditors as an alternative to formal insolvency
proceedings (i.e. the debt is restructured). During the
2012 Greek government-debt crisis, one important
issue was whether the restructuring would trigger
Credit default swap (CDS) payments. European
Central Bank and the International Monetary Fund
negotiators avoided these triggers as they could have
jeopardized the stability of major European banks who
had been protection writers. An alternative could have
been to create new CDS which clearly would pay in
the event of debt restructuring. The market would have
paid the spread between these and old (potentially
more ambiguous) CDS. This practice is far more
typical in jurisdictions that do not provide protective
status to insolvent debtors similar to that provided by
Chapter 11 of the United States Bankruptcy Code. In
particular, concerns arising out of Conseco's
restructuring in 2000 led to the credit event's removal
from North American high yield trades.[87]

Settlement
Sovereign credit default swap prices of selected
European countries (2010-2011). The left axis is
Physical or cash basis points, or 100ths of a percent; a level of
1,000 means it costs $1 million per year to protect
As described in an earlier section, if a credit event $10 million of debt for five years.
occurs then CDS contracts can either be physically
settled or cash settled.[7]

Physical settlement: The protection seller pays the buyer par value, and in return takes
delivery of a debt obligation of the reference entity. For example, a hedge fund has bought
$5 million worth of protection from a bank on the senior debt of a company. In the event of a
default, the bank pays the hedge fund $5 million cash, and the hedge fund must deliver
$5 million face value of senior debt of the company (typically bonds or loans, which are
typically worth very little given that the company is in default).
Cash settlement: The protection seller pays the buyer the difference between par value and
the market price of a debt obligation of the reference entity. For example, a hedge fund has
bought $5 million worth of protection from a bank on the senior debt of a company. This
company has now defaulted, and its senior bonds are now trading at 25 (i.e., 25 cents on the
dollar) since the market believes that senior bondholders will receive 25% of the money they
are owed once the company is wound up (all the defaulting company's liquidable assets are
sold off). Therefore, the bank must pay the hedge fund $5 million × (100% − 25%)
= $3.75 million.

The development and growth of the CDS market has meant that on many companies there is now a much
larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations.
(This is because many parties made CDS contracts for speculative purposes, without actually owning any
debt that they wanted to insure against default. See "naked" CDS) For example, at the time it filed for
bankruptcy on September 14, 2008, Lehman Brothers had approximately $155 billion of outstanding
debt[88] but around $400 billion notional value of CDS contracts had been written that referenced this
debt.[89] Clearly not all of these contracts could be physically settled, since there was not enough
outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for cash settled
CDS trades. The trade confirmation produced when a CDS is traded states whether the contract is to be
physically or cash settled.

Auctions

When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction
(also known as a credit-fixing event) may be held to facilitate settlement of a large number of contracts at
once, at a fixed cash settlement price. During the auction process participating dealers (e.g., the big
investment banks) submit prices at which they would buy and sell the reference entity's debt obligations, as
well as net requests for physical settlement against par. A second stage Dutch auction is held following the
publication of the initial midpoint of the dealer markets and what is the net open interest to deliver or be
delivered actual bonds or loans. The final clearing point of this auction sets the final price for cash
settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting
from the auction are actually settled. According to the International Swaps and Derivatives Association
(ISDA), who organised them, auctions have recently proved an effective way of settling the very large
volume of outstanding CDS contracts written on companies such as Lehman Brothers and Washington
Mutual.[90] Commentator Felix Salmon, however, has questioned in advance ISDA's ability to structure an
auction, as defined to date, to set compensation associated with a 2012 bond swap in Greek government
debt.[91] For its part, ISDA in the leadup to a 50% or greater "haircut" for Greek bondholders, issued an
opinion that the bond swap would not constitute a default event.[92]

Below is a list of the auctions that have been held since 2005.[93][94]
 Final price as a
Date Name
percentage of par

2005-06-
Collins & Aikman - Senior 43.625
14

2005-06-
Collins & Aikman - Subordinated 6.375
23
2005-10-
Northwest Airlines 28
11

2005-10-
Delta Air Lines 18
11

2005-11-
Delphi Corporation 63.375
04
2006-01-
Calpine Corporation 19.125
17

2006-03-
Dana Holding Corporation 75
31

2006-11-
Dura - Senior 24.125
28
2006-11-
Dura - Subordinated 3.5
28

2007-10-
Movie Gallery 91.5
23

2008-02-
Quebecor World 41.25
19
2008-10-
Tembec Inc 83
02

2008-10-
Fannie Mae - Senior 91.51
06

2008-10-
Fannie Mae - Subordinated 99.9
06
2008-10-
Freddie Mac - Senior 94
06

2008-10-
Freddie Mac - Subordinated 98
06
2008-10-
Lehman Brothers 8.625
10

2008-10-
Washington Mutual 57
23

2008-11-
Landsbanki - Senior 1.25
04
2008-11-
Landsbanki - Subordinated 0.125
04

2008-11-
Glitnir - Senior 3
05

2008-11-
Glitnir - Subordinated 0.125
05
2008-11-
Kaupthing - Senior 6.625
06
2008-11-
Kaupthing - Subordinated 2.375
06
2008-12-
Masonite [2] (http://www.masonite.com/) - LCDS 52.5
09

2008-12-
Hawaiian Telcom - LCDS 40.125
17

2009-01-
Tribune - CDS 1.5
06
2009-01-
Tribune - LCDS 23.75
06

2009-01-
Republic of Ecuador 31.375
14

2009-02-
Millennium America Inc 7.125
03
2009-02-
Lyondell - CDS 15.5
03

2009-02-
Lyondell - LCDS 20.75
03

2009-02-
EquiStar 27.5
03
2009-02-
Sanitec [3] (http://www.sanitec.com/) - 1st Lien 33.5
05

2009-02-
Sanitec [4] (http://www.sanitec.com/) - 2nd Lien 4.0
05

2009-02- British Vita [5] (https://web.archive.org/web/20110208031341/http://bri

15.5
09 tishvita.com/) - 1st Lien
2009-02- British Vita [6] (https://web.archive.org/web/20110208031341/http://bri
2.875
09 tishvita.com/) - 2nd Lien

2009-02-
Nortel Ltd. 6.5
10

2009-02-
Nortel Corporation 12
10
2009-02-
Smurfit-Stone CDS 8.875
19

2009-02-
Smurfit-Stone LCDS 65.375
19

2009-02-
Ferretti 10.875
26
2009-03-
Aleris 8
09

2009-03-
Station Casinos 32
31

2009-04-
Chemtura 15
14
2009-04-
Great Lakes 18.25
14

2009-04-
Rouse 29.25
15
2009-04-
LyondellBasell 2
16
2009-04-
Abitibi 3.25
17

2009-04-
Charter Communications CDS 2.375
21

2009-04-
Charter Communications LCDS 78
21
2009-04-
Capmark 23.375
22

2009-04-
Idearc CDS 1.75
23

2009-04-
Idearc LCDS 38.5
23
2009-05-
Bowater 15
12

2009-05-
General Growth Properties 44.25
13

2009-05-
Syncora 15
27
2009-05-
Edshcha 3.75
28

2009-06-
HLI Operating Corp LCDS 9.5
09

2009-06-
Georgia Gulf LCDS 83
10
2009-06-
R.H. Donnelley Corp. CDS 4.875
11

2009-06-
General Motors CDS 12.5
12

2009-06-
General Motors LCDS 97.5
12
2009-06-
JSC Alliance Bank CDS 16.75
18

2009-06-
Visteon CDS 3
23

2009-06-
Visteon LCDS 39
23
2009-06-
RH Donnelley Inc LCDS 78.125
24

2009-07-
Six Flags CDS 14
09

2009-07-
Six Flags LCDS 96.125
09
2009-07-
Lear CDS 38.5
21

2009-07-
Lear LCDS 66
21
2009-11-
METRO-GOLDWYN-MAYER INC. LCDS 58.5
10
2009-11-
CIT Group Inc. 68.125
20

2009-12-
Thomson 77.75
09

2009-12-
Hellas II 1.375
15
2009-12-
NJSC Naftogaz of Ukraine 83.5
16

2010-01-
Financial Guarantee Insurance Compancy (FGIC) 26
07

2010-02-
CEMEX 97.0
18
2010-03-
Aiful 33.875
25

2010-04-
McCarthy and Stone 70.375
15

2010-04-
Japan Airlines Corp 20.0
22
2010-06-
Ambac Assurance Corp 20.0
04

2010-07-
Truvo Subsidiary Corp 3.0
15

2010-09-
Truvo (formerly World Directories) 41.125
09
2010-09-
Boston Generating LLC 40.75
21

2010-10-
Takefuji Corp 14.75
28

2010-12-
Anglo Irish Bank 18.25
09
2010-12-
Ambac Financial Group 9.5
10

2011-11-
Dynegy Holdings, LLC 71.25
29

2011-12-
Seat Pagine Gialle 10.0
09
2011-12-
PMI Group 16.5
13

2011-12-
AMR Corp 23.5
15

2012-02-
Eastman Kodak Co 22.875
22
2012-03-
Hellenic Republic 21.75
19

2012-03-
Elpida Memory 20.125
22
 2012-03-
ERC Ireland Fin Ltd 0.0
29
2012-05-
Sino Forest Corp 29.0
09

2012-05-
Houghton Mifflin Harcourt Publishing Co 55.5
30

2012-06-
Residential Cap LLC 17.625
06
2015-02-
Caesars Entmt Oper Co Inc 15.875
19

2015-03-
Radio Shack Corp 11.5
05

2015-06-
Sabine Oil Gas Corp 15.875
23
2015-09-
Alpha Appalachia Hldgs Inc 6
17

2015-10-
Ukraine 80.625
06

Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default swaps. The first,
referred to herein as the 'probability model', takes the present value of a series of cashflows weighted by
their probability of non-default. This method suggests that credit default swaps should trade at a
considerably lower spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by John Hull and Alan White, uses a no-arbitrage
approach.

Probability model

Under the probability model, a credit default swap is priced using a model that takes four inputs; this is
similar to the rNPV (risk-adjusted NPV) model used in drug development:

the "issue premium",

the recovery rate (percentage of notional repaid in event of default),
the "credit curve" for the reference entity and
the "LIBOR curve".

If default events never occurred the price of a CDS would simply be the sum of the discounted premium
payments. So CDS pricing models have to take into account the possibility of a default occurring some time
between the effective date and maturity date of the CDS contract. For the purpose of explanation we can
imagine the case of a one-year CDS with effective date with four quarterly premium payments occurring
at times , , , and . If the nominal for the CDS is and the issue premium is then the size of the
quarterly premium payments is . If we assume for simplicity that defaults can only occur on one of
the payment dates then there are five ways the contract could end:

either it does not have any default at all, so the four premium payments are made and the
contract survives until the maturity date, or
 a default occurs on the first, second, third or fourth payment date.

To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the
present value of the payoff for each outcome. The present value of the CDS is then simply the present
value of the five payoffs multiplied by their probability of occurring.

This is illustrated in the following tree diagram where at each payment date either the contract has a default
event, in which case it ends with a payment of shown in red, where is the recovery rate, or it
survives without a default being triggered, in which case a premium payment of is made, shown in
blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue
and default payments in red. If the contract is terminated the square is shown with solid shading.

The probability of surviving over the interval to without a default payment is and the probability
of a default being triggered is . The calculation of present value, given discount factor of to is
then

Description Premium Payment PV Default Payment PV Probability

Default at time

Default at time

Default at time

Default at time

No defaults
The probabilities , , , can be calculated using the credit spread curve. The probability of no
default occurring over a time period from to decays exponentially with a time-constant
determined by the credit spread, or mathematically where is the credit
spread zero curve at time . The riskier the reference entity the greater the spread and the more rapidly the
survival probability decays with time.

To get the total present value of the credit default swap we multiply the probability of each outcome by its
present value to give

Grouped by cash flow direction (receiving protection and paying premium):

No-arbitrage model

In the "no-arbitrage" model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free
arbitrage. Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the
risk free rate. Both analyses make simplifying assumptions (such as the assumption that there is zero cost of
unwinding the fixed leg of the swap on default), which may invalidate the no-arbitrage assumption.
However the Duffie approach is frequently used by the market to determine theoretical prices.

Criticisms
Critics of the huge credit default swap market have claimed that it has been allowed to become too large
without proper regulation and that, because all contracts are privately negotiated, the market has no
transparency. Furthermore, there have been claims that CDSs exacerbated the 2008 global financial crisis
by hastening the demise of companies such as Lehman Brothers and AIG.[52]

In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced
confidence in the bank and ultimately gave it further problems that it was not able to overcome. However,
proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the
reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed
investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their
default.
Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during
the 2009 General Motors Chapter 11 reorganization, because certain bondholders might benefit from the
credit event of a GM bankruptcy due to their holding of CDSs. Critics speculate that these creditors had an
incentive to push for the company to enter bankruptcy protection.[95] Due to a lack of transparency, there
was no way to identify the protection buyers and protection writers.[96]

It was also feared at the time of Lehman's bankruptcy that the $400 billion notional of CDS protection
which had been written on the bank could lead to a net payout of $366 billion from protection sellers to
buyers (given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts
could lead to further bankruptcies of firms without enough cash to settle their contracts.[97] However,
industry estimates after the auction suggest that net cashflows were only in the region of $7 billion.[97]
because many parties held offsetting positions. Furthermore, CDS deals are marked-to-market frequently.
This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, reducing the
net cashflows on the days after the auction.[90]

Senior bankers have argued that not only has the CDS market functioned remarkably well during the
financial crisis; that CDS contracts have been acting to distribute risk just as was intended; and that it is not
CDSs themselves that need further regulation but the parties who trade them.[98]

Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett
famously described derivatives bought speculatively as "financial weapons of mass destruction." In
Berkshire Hathaway's annual report to shareholders in 2002, he said, "Unless derivatives contracts are
collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties
to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—
often huge in amount—in their current earnings statements without so much as a penny changing hands.
The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems,
madmen)."[99]

To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on
one's counterparty. The positions are marked-to-market daily and collateral pass from buyer to seller or vice
versa to protect both parties against counterparty default, but money does not always change hands due to
the offset of gains and losses by those who had both bought and sold protection. Depository Trust &
Clearing Corporation, the clearinghouse for the majority of trades in the US over-the-counter market, stated
in October 2008 that once offsetting trades were considered, only an estimated $6 billion would change
hands on October 21, during the settlement of the CDS contracts issued on Lehman Brothers' debt, which
amounted to somewhere between $150 and $360 billion.[100]

Despite Buffett's criticism on derivatives, in October 2008 Berkshire Hathaway revealed to regulators that it
has entered into at least $4.85 billion in derivative transactions.[101] Buffett stated in his 2008 letter to
shareholders that Berkshire Hathaway has no counterparty risk in its derivative dealings because Berkshire
require counterparties to make payments when contracts are initiated, so that Berkshire always holds the
money.[102] Berkshire Hathaway was a large owner of Moody's stock during the period that it was one of
two primary rating agencies for subprime CDOs, a form of mortgage security derivative dependent on the
use of credit default swaps.
The monoline insurance companies got involved with writing credit default swaps on mortgage-backed
CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the
monolines.[103][104] In 2009 one of the monolines, MBIA, sued Merrill Lynch, claiming that Merrill had
misrepresented some of its CDOs to MBIA in order to persuade MBIA to write CDS protection for those
CDOs.[105][106][107]

Systemic risk

During the 2008 financial crisis, counterparties became subject to a risk of default, amplified with the
involvement of Lehman Brothers and AIG in a very large number of CDS transactions. This is an example
of systemic risk, risk which threatens an entire market, and a number of commentators have argued that size
and deregulation of the CDS market have increased this risk.

For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds
in 2005 and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After
Lehman's default, this protection was no longer active, and Washington Mutual's sudden default only days
later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS.
There was also fear that Lehman Brothers and AIG's inability to pay out on CDS contracts would lead to
the unraveling of complex interlinked chain of CDS transactions between financial institutions.[108]

Chains of CDS transactions can arise from a practice known as "netting".[109] Here, company B may buy a
CDS from company A with a certain annual premium, say 2%. If the condition of the reference company
worsens, the risk premium rises, so company B can sell a CDS to company C with a premium of say, 5%,
and pocket the 3% difference. However, if the reference company defaults, company B might not have the
assets on hand to make good on the contract. It depends on its contract with company A to provide a large
payout, which it then passes along to company C.

The problem lies if one of the companies in the chain fails, creating a "domino effect" of losses. For
example, if company A fails, company B will default on its CDS contract to company C, possibly resulting
in bankruptcy, and company C will potentially experience a large loss due to the failure to receive
compensation for the bad debt it held from the reference company. Even worse, because CDS contracts are
private, company C will not know that its fate is tied to company A; it is only doing business with company
B.

As described above, the establishment of a central exchange or clearing house for CDS trades would help
to solve the "domino effect" problem, since it would mean that all trades faced a central counterparty
guaranteed by a consortium of dealers.

Tax and accounting issues

The U.S federal income tax treatment of CDS is uncertain (Nirenberg and Kopp 1997:1, Peaslee &
Nirenberg 2008-07-21:129 and Brandes 2008).[110][111][112][notes 2] Commentators have suggested that,
depending on how they are drafted, they are either notional principal contracts or options for tax purposes,
(Peaslee & Nirenberg 2008-07-21:129).[111] but this is not certain. There is a risk of having CDS
recharacterized as different types of financial instruments because they resemble put options and credit
guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and
binary/FMV) and trigger (default only/any credit event) (Nirenberg & Kopp 1997:8).[110] And, as noted
below, the appropriate treatment for Naked CDS may be entirely different.
If a CDS is a notional principal contract, pre-default periodic and nonperiodic payments on the swap are
deductible and included in ordinary income.[113] If a payment is a termination payment, or a payment
received on a sale of the swap to a third party, however, its tax treatment is an open question.[113] In 2004,
the Internal Revenue Service announced that it was studying the characterization of CDS in response to
taxpayer confusion.[114] As the outcome of its study, the IRS issued proposed regulations in 2011
specifically classifying CDS as notional principal contracts, and thereby qualifying such termination and
sale payments for favorable capital gains tax treatment.[115] These proposed regulations, which are yet to
be finalized, have already been subject to criticism at a public hearing held by the IRS in January 2012,[116]
as well as in the academic press,[117] insofar as that classification would apply to Naked CDS.

The thrust of this criticism is that Naked CDS are indistinguishable from gambling wagers, and thus give
rise in all instances to ordinary income, including to hedge fund managers on their so-called carried
interests,[117] and that the IRS exceeded its authority with the proposed regulations. This is evidenced by
the fact that Congress confirmed that certain derivatives, including CDS, do constitute gambling when, in
2000, to allay industry fears that they were illegal gambling,[118] it exempted them from "any State or local
law that prohibits or regulates gaming."[119] While this decriminalized Naked CDS, it did not grant them
relief under the federal gambling tax provisions.

The accounting treatment of CDS used for hedging may not parallel the economic effects and instead,
increase volatility. For example, GAAP generally require that CDS be reported on a mark to market basis.
In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost,
unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can
induce considerable volatility into the income statement and balance sheet as the CDS changes value over
its life due to market conditions and due to the tendency for shorter dated CDS to sell at lower prices than
longer dated CDS. One can try to account for the CDS as a hedge under FASB 133[120] but in practice that
can prove very difficult unless the risky asset owned by the bank or corporation is exactly the same as the
Reference Obligation used for the particular CDS that was bought.

LCDS
A new type of default swap is the "loan only" credit default swap (LCDS). This is conceptually very
similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated
secured loans of the Reference Entity rather than the broader category of "Bond or Loan". Also, as of May
22, 2007, for the most widely traded LCDS form, which governs North American single name and index
trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement.
The auction method is essentially the same that has been used in the various ISDA cash settlement auction
protocols, but does not require parties to take any additional steps following a credit event (i.e., adherence
to a protocol) to elect cash settlement. On October 23, 2007, the first ever LCDS auction was held for
Movie Gallery.[121]

Because LCDS trades are linked to secured obligations with much higher recovery values than the
unsecured bond obligations that are typically assumed the cheapest to deliver in respect of vanilla CDS,
LCDS spreads are generally much tighter than CDS trades on the same name.

ISDA Definitions
During the rapid growth of the credit derivatives market the 1999 ISDA Credit Derivatives Definitions[122]
were introduced to standardize the legal documentation of CDS. Subsequently, replaced with the 2003
ISDA Credit Derivatives Definitions,[123] and later the 2014 ISDA Credit Derivatives Definitions,[124]
each definition update seeks to ensure the CDS payoffs closely mimic the economics of the underlying
reference obligations (bonds).

See also
Bucket shop (stock market)
Constant maturity credit default swap
Credit default option
Credit default swap index
CUSIP Linked MIP Code, reference entity code
Inside Job (2010 film), an Oscar-winning documentary film about the financial crisis of 2007–
2010 by Charles H. Ferguson
PAUG
Recovery swap
Toxic security
Intercontinental Exchange

Notes
1. Intercontinental Exchange's closest rival as credit default swaps (CDS) clearing houses,
CME Group (CME) cleared $192 million in comparison to ICE's $10 trillion (Terhune
Bloomberg Business Week 2010-07-29).
2. The link is to an earlier version of this paper.

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External links
Barroso considers ban on speculation with banning purely speculative naked sales on credit
default swaps of sovereign debt (https://web.archive.org/web/20100526102005/http://www.e
uractiv.com/en/euro/barroso-considers-ban-speculation-sovereign-debt-news-325532)
CBS '60 minutes' video on CDS (http://www.cbsnews.com/video/watch/?id=4546583n&tag=
mncol;lst;3)
2003 ISDA Credit Derivatives Template (https://web.archive.org/web/20170330144712/http://
www.isda.org/publications/copyrightspolicy.html). International Swaps and Derivatives
Association
Understanding Derivatives: Markets and Infrastructure (https://web.archive.org/web/2013081
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A Beginner's Guide to Credit Derivatives (https://web.archive.org/web/20070928121759/htt
p://www.probability.net/credit.pdf) - Nomura International Probability.net
"A billion-dollar game for bond managers" (https://www.ft.com/cms/s/e463523a-62b4-11db-8
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 Duffie, Darrell (1998). "Credit Swap Valuation". Stanford Graduate School of Business.
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John C. Hull and Alan White. "Valuing Credit Default Swaps I: No Counterparty Default
Risk" (https://web.archive.org/web/20061112185612/http://www.rotman.utoronto.ca/%7Ehull/
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Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations (htt
p://www.smartquant.com/references/SWAP/swap2.pdf). Smartquant.com
Elton et al., Explaining the rate spread on corporate bonds (http://pages.stern.nyu.edu/~mgru
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Warren Buffett on Derivatives - Excerpts from the Berkshire Hathaway annual report for
2002. (http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf)
fintools.com
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"The AIG Bailout" (https://ssrn.com/abstract=1346552) William Sjostrom, Jr.
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&ie=UTF-8&u=http%3A%2F%2Fverlorenegeneration.de%2Flanderisiken-im-uberblick%2F
&sl=de&tl=en&history_state0=)

News
Zweig, Phillip L. (July 1997), BusinessWeek New ways to dice up debt - Suddenly, credit
derivatives-deals that spread credit risk--are surging (https://web.archive.org/web/20090113
144113/http://www.businessweek.com/archives/1997/b3536094.arc.htm)
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Unnerve Markets (https://www.wsj.com/articles/SB120061980722699349)"
Das, Satayjit (February 5, 2008), Financial Times: "CDS market may create added risks (http
s://www.ft.com/cms/s/0/f75c80e4-d3fd-11dc-a8c6-0000779fd2ac.html)"
Morgenson, Gretchen (February 17, 2008), New York Times: "Arcane Market is Next to Face
Big Credit Test (https://www.nytimes.com/2008/02/17/business/17swap.html?pagewanted=1
&_r=1&ref=todayspaper)"
March 17, 2008 Credit Default Swaps: The Next Crisis? (https://web.archive.org/web/20080
318134225/http://www.time.com/time/business/article/0,8599,1723152,00.html), Time
Schwartz, Nelson D. and Creswell, Julie (March 23, 2008), New York Times: "Who Created
This Monster? (https://www.nytimes.com/2008/03/23/business/23how.html)"
Evans, David (May 20, 2008), Bloomberg: "Hedge Funds in Swaps Face Peril With Rising
Junk Bond Defaults (https://www.bloomberg.com/apps/news?pid=20601109&sid=aCFGw7
GYxY14)"
van Duyn, Aline (May 28, 2008), Financial Times: "Moody's issues warning on CDS risks (ht
tps://web.archive.org/web/20081004203107/http://us.ft.com/ftgateway/superpage.ft?news_id
=fto052820081032091987)"
 Morgenson, Gretchen (June 1, 2008), New York Times: "First Comes the Swap. Then It’s the
Knives. (https://www.nytimes.com/2008/06/01/business/01gret.html)"
Kelleher, James B. (September 18, 2008), Reuters: "Buffett's 'time bomb' goes off on Wall
Street. (https://www.reuters.com/article/newsOne/idUSN1837154020080918?sp=true)"
Morgenson, Gretchen (September 27, 2008), New York Times: "Behind Insurer’s Crisis,
Blind Eye to a Web of Risk (https://www.nytimes.com/2008/09/28/business/28melt.html?e
m)"
Varchaver, Nicholas and Benner, Katie (Sep 2008), Fortune Magazine: "The $55 Trillion
Question (https://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_shor
t.fortune/index.htm?postversion=2008093012)" - on CDS spotlight during financial crisis.
Dizard, John (October 23, 2006). "A billion dollar game" (https://web.archive.org/web/200904
06073413/http://us.ft.com/ftgateway/superpage.ft?news_id=fto102320061114181979).
Financial Times. Archived from the original (http://us.ft.com/ftgateway/superpage.ft?news_id
=fto102320061114181979) on April 6, 2009. Retrieved October 19, 2008.
October 19, 2008, Portfolio.com: "Why the CDS Market Didn't Fail (http://www.portfolio.com/v
iews/blogs/market-movers/2008/10/19/why-the-cds-market-didnt-fail)" Analyzes the CDS
market's performance in the Lehman Bros. bankruptcy.
Boumlouka, Makrem (April 8, 2009), Wall Street Letter: "Credit Default Swap Market: "Big
Bang"? (http://www.wallstreetletter.com/Article.aspx?ArticleID=2177796)".

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