What is a Credit Default Swap?

Credit default swaps (CDS) are the most common credit derivatives in foreign bond markets. ^{[1] It is} actually a contract in which buyers and sellers perform risk conversion on a designated credit event within a certain period of time. The buyer of credit risk protection regularly pays the seller of credit risk protection for the credit event of a reference entity during the contract period or before the occurrence of a credit event in exchange for compensation after the credit event occurs ^[2] .

Credit default swap

On March 24, 1989,

CDS is actually a contract in which buyers and sellers perform risk conversion on a specified credit event within a certain period. The buyer of credit risk protection regularly pays the seller of credit risk protection for the credit event of a reference entity during the contract period or before the occurrence of a credit event in exchange for compensation after the credit event ^[2]

CDS can be classified according to different dimensions. For example, according to different reference entities, they can be divided into enterprise classes or sovereign classes. Sovereignty here can be the state, the government's political institutions, the central bank, and so on. Companies in the reference entity currently account for approximately 70% of the total CDS nominal principal ^[2]

The main feature of CDS is its high leverage. Unlike buying bonds, upfront investment in CDS does not require or requires only a small amount of capital investment. One reason is that protecting buyers only needs to pay coupons on a quarterly basis, while protecting sellers only requires

Credit default swap advantages

The advantages of CDS are reflected in the increase of credit funds in the market. At present, Chinese banks are the main providers of market funds, but because of their own risk control and restrictions on various indicators, banks are unwilling to lend and are not willing to lend abroad. It can be seen from the above case of JP Morgan Chase Bank that CDS can allow banks to release credit risk.

CDS provides credit risk transfer channels for fund lenders, which helps banks to adopt precise risk management tools without the need to sell credit, bonds or frequent asset portfolio replacements. Through off-balance sheet support, credit risk can be reduced without reducing the size of assets. This is a good application tool for the management philosophy that Chinese banks are still pursuing scale and hope to reduce credit risk.

Because the CDS buyer actually provides insurance for the reference entity, by providing CDS, weak rating companies provide guarantees for their lenders, which can indirectly reduce cost financing. It is reported that recently Shanxi Finance Office is preparing to establish a Shanxi Credit Enhancement Investment Company to increase the credit of coal enterprises in Shanxi Province through CDS and expand bond financing. This is the method adopted. In addition, because of its scale and liquidity, CDS is significantly higher than reference bonds, so it can provide holders of current bonds with a guarantee channel to better manage the risk of bonds held.

Especially in perfect financial markets, it is essential to identify risky financial instruments. If you can only go long and not short, the market asset bubble will be difficult to find. Once it falls, the magnitude will be more severe. CDS coupons are more dynamic for market information. The study found that CDS coupons are better able to reflect changes in the risk of the reference entity than ratings by rating companies. Because CDS provides a more agile spot price discovery channel, the cost of credit risk for hedging spot holdings is reduced, and the spot price can be kept within a reasonable range. ^[5]

Credit default swap disadvantages

The main disadvantage of CDS is that the buyer of CDS still retains the right to speak to the debtor after transferring credit risk, especially if the reference entity has bankruptcy or debt restructuring.

Another disadvantage of CDS is bare space. A study of the 2008 financial market crisis found that 80% of CDS contracts were bare. The EU market has begun banning naked speculation after the crisis.

Although CDS can increase the investment of market credit funds, some people believe that this will prompt banks to increase lending to high-risk projects and reduce the quality of lending. It will also easily cause banks to relax their follow-up lending and generate moral hazard.

CDS is an over-the-counter bilateral transaction, which lacks the standardization of exchange products and has significant counterparty risk. After the crisis, the supervisory department began to strengthen the central clearing center, which greatly controlled the counterparty risk, and at the same time had timely monitoring of the market size and potential risks.