Policy Documents

Credit Default Swaps

Matthew Glans –
November 25, 2008

First offered by JP Morgan in 1997, credit default swaps (CDS) are the most widely used type of credit derivative in the market and an influential force in the financial marketplace (http://www.investopedia.com/articles/optioninvestor/08/cds.asp?viewall=1).

A credit default swap involves movement of the credit risk from a bond, mortgage-backed security, or corporate debt from one party to another. The buyer of a CDS gets protection from the negative consequences of a default. The seller of the CDS receives a fee from the buyer. A CDS is essentially a form of insurance, and like all providers of insurance, the sellers of a CDS expose themselves to considerable risk. Should the bond default, it is the seller of the CDS who will be held responsible for all negative consequences.

Credit default swaps are traded at a very high volume by investors attempting to hedge their investments and speculators betting on the credit-worthiness of the companies involved in the transaction. An investor can sell its share in the CDS contract at any time, which leads to the frequent trading of CDSs by speculators seeking to profit on the credit health of a company (http://www.investopedia.com/articles/optioninvestor/08/cds.asp?viewall=1).

Credit default swaps are traded over the counter (OTC) and are currently not regulated by the government. Their value is determined primarily by the likelihood of a credit event occurring to the bond holder. Because CDSs are traded primarily among banks, insurers, and hedge funds directly, a default of a major dealer could have far-reaching negative effects on the market.

Because CDSs are traded over the counter privately between two parties, critics argue the swaps lack transparency and more regulation is needed to reduce the risk of a systemic collapse of the market spreading from the CDS market. They say that creating derivatives contracts without adequate collateral or guarantees and relying solely on the creditworthiness of a CDS seller risks massive loss to all parties in the event of default (http://www.bloomberg.com/apps/news?pid=20601009&sid=aaUUGpMC7yDw&refer=bond).

Some economists claim the failure of several banks may have occurred as a direct result of the unregulated credit default swap market. They say the interconnected bilateral transactions of the unregulated OTC credit default swap market magnified the economic backlash that originated in the subprime mortgage market. Creating a domino effect, the failure of one bank, burdened by failing mortgage securities hedged by CDSs, caused a chain reaction that weakened the holdings of multiple banks, leading to further defaults, restarting the chain again. (http://seekingalpha.com/article/99585-misconceptions-on-the-credit-default-swap-market).

Credit default swaps are the most often-used type of credit derivative. Their value as a hedging and speculation tool is well documented, but they may have outgrown their over-the-counter days and need to move towards a new model that allows for greater transparency and accountability. Instead of creating a new layer of government bureaucracy and regulation, the CDS market should move towards a privately run exchange model. An exchange would formalize the swap contracts while creating a structured system of rules requiring both parties to more adequately prove they are well prepared and fiscally capable of honoring their sides of the contract. This would address many of the concerns of critics while not suppressing a vital and growing sector of the market (http://news.medill.northwestern.edu/chicago/news.aspx?id=100773).

Efforts to create such an exchange are currently underway. The government should support these efforts and not push through regulatory regimes that hinder the ability of these swaps to be made.

The following articles address this issue and examine credit default swaps from a free-market perspective.

Credit Default Swaps: An Introduction
http://www.investopedia.com/articles/optioninvestor/08/cds.asp?viewall=1
This article, written by Wayne Pinsent of Forbes, presents a basic overview of the credit default swap market, focusing on how and why investors use credit default swaps as a hedging and speculation tool.

Credit Default Swaps Are Good For You
http://www.forbes.com/opinions/2008/10/20/buffett-lehman-derivatives-oped-cx_sf_rcs_1020figlewskismith.html
Stephen Figlewski and Roy C. Smith of the Stern School of Business at NYU examine the positive role that credit default swaps play in the economy and how the market could be improved without additional government intervention.

Misconceptions on the Credit Default Swap Market
http://seekingalpha.com/article/99585-misconceptions-on-the-credit-default-swap-market
This article examines some of the misconceptions of the CDS market being claimed by critics, arguing that the effect of CDS markets on the current economic crisis has been overstated and that the failure of Lehman Brothers was not the sole result of credit default swaps.

Why the CDS Market Didn't Fail
http://seekingalpha.com/article/100696-why-the-cds-market-didn-t-fail
This article examines the role of the CDS market in the current economic crisis and explains how the CDS markets had a limited role in the downturn.

CME Urges Exchange-Based Market for Credit Default Swaps
http://news.medill.northwestern.edu/chicago/news.aspx?id=100773
This article studies one of the free-market solutions to regulating the now over-the-counter CDS market, a private exchange. Championed by the Chicago Mercantile Exchange, the new exchange would allow for greater transparency and regulation without a new government bureaucracy.

Swaps Platform Gets a Boost
http://online.wsj.com/article/SB122601902407007147.html?mod=googlenews_wsj
This article examines the different clearinghouse proposals being made by various entities, like the Chicago Mercantile Exchange, EuroNext, and Intercontinental Exchange Inc, to regulate the CDS market. The benefits of the clearinghouse plan are explained.

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit The Heartland Institute's Web site at http://www.heartland.org and PolicyBot, Heartland's free online research database.

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