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[[File:CDS-nodefault.PNG|300px|thumb|If the reference bond performs without default, the protection buyer pays quarterly payments to the seller until maturity]]
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[[File:CDS-default.PNG|300px|thumb|If the reference bond defaults, the protection seller pays par value of the bond to the buyer, and the buyer transfers ownership of the bond to the seller]]
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A '''credit default swap''' ('''CDS''') is a [[Swap (finance)|financial swap]] agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan [[Default (finance)|default]] (by the debtor) or other [[credit event]]. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by [[Blythe Masters]]  from [[J.P. Morgan & Co.|JP Morgan]] in 1994.
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In the event of default the buyer of the CDS receives compensation (usually the [[face value]] of the loan), and the seller of the CDS takes possession of the defaulted loan.<ref name="LBO CDS" />  However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no 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 default swap#Auctions|credit event auction]]; the payment received is usually substantially less than the face value of the loan.<ref>{{cite web |url=http://ftalphaville.ft.com/blog/2012/01/05/779501/why-do-they-exist/ |title=Credit event auctions: Why do they exist? |work=FT Alphaville |first= Lisa |last=Pollack |date=January 5, 2012 |accessdate=January 5, 2012}}</ref>
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Credit default swaps have existed since the early 1990s, and increased in use after 2003.  By the end of 2007, the outstanding CDS amount was $62.2&nbsp;trillion,<ref name='ISDA Annual Chart'>{{cite web|url=http://www.isda.org/statistics/pdf/ISDA-Market-Survey-annual-data.pdf |title=Chart; ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts, 1987-present |accessdate=April 8, 2010 |format=PDF |publisher=[[International Swaps and Derivatives Association]] (ISDA)}}</ref> falling to $26.3&nbsp;trillion by mid-year 2010<ref name="test">[http://www.isda.org/statistics/recent.html ISDA 2010 MID-YEAR MARKET SURVEY]. Latest available a/o 2012-03-01.</ref> but reportedly $25.5<ref>{{cite web|url=http://www.isdacdsmarketplace.com/market_statistics |title=ISDA: CDS Marketplace :: Market Statistics |publisher=Isdacdsmarketplace.com |date=December 31, 2010 |accessdate=March 12, 2012}}</ref>&nbsp;trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.<ref name='IMF254'>{{cite journal |title=Credit Derivatives: Systemic Risks and Policy Options |journal=International Monetary Fund: IMF Working Paper |date=November 2009|first=John |last=Kiff |author2=Jennifer Elliott |author3=Elias Kazarian |author4=Jodi Scarlata |author5=Carolyne Spackman  |volume= |issue=WP/09/254 |pages= |url=http://www.imf.org/external/pubs/ft/wp/2009/wp09254.pdf |format=PDF |accessdate=April 25, 2010 }}</ref> During the [[Financial crisis of 2007–2010|2007-2010 financial crisis]] the lack of transparency in this large market became a concern to regulators as it could pose a [[systemic risk]].<ref name='Deutsche Bank Report' /><ref name="SimkovicSecret">Simkovic, Michael, [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1323190 Secret Liens and the Financial Crisis of 2008].</ref><ref name='Sirri Testimony' /><ref name='Partnoy Article'>{{cite journal |title=The Promise And Perils of Credit Derivatives |journal=University of Cincinnati Law Review |year=2007 |first=Frank |last=Partnoy |authorlink=Frank Partnoy |coauthors=David A. Skeel, Jr. |volume=75 |issue= |pages=1019–1051 |ssrn=929747}}</ref> In March 2010, the [DTCC] Trade Information Warehouse (see [[#Sources of market data|Sources of Market Data]]) announced it would give regulators greater access to its credit default swaps database.<ref>{{cite web |url=http://www.dtcc.com/news/press/releases/2010/data_release_policy.php |title=Media Statement: DTCC Policy for Releasing CDS Data to Global Regulators |accessdate=April 22, 2010 |date=March 23, 2010 |publisher=Depository Trust & Clearing Corporation }}</ref>
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CDS data can be used by [[financial risk management|financial professionals]], 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 agency|Credit Rating Agencies]].  U.S. Courts may soon be following suit.<ref name="LBO CDS">Simkovic, Michael, [http://ssrn.com/abstract=1632084 "Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution"], ''Columbia Business Law Review'' (Vol. 2011, No. 1, pp. 118), 2011.</ref>
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Most CDSs are documented using standard forms drafted by the [[International Swaps and Derivatives Association|International Swaps and Derivatives Association (ISDA)]], although there are many variants.<ref name="Deutsche Bank Report"/>  In addition to the basic, single-name swaps, there are [[basket (finance)|basket]] default swaps (BDSs), index CDSs, funded CDSs (also called [[credit-linked note]]s), 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 security|asset-backed securities]].<ref name='Mengle Overview'>{{cite journal |title=Credit Derivatives: An Overview |journal=Economic Review (FRB Atlanta)|date=Fourth Quarter 2007 |first=David |last=Mengle |volume=92 |issue=4 |pages= |url=http://www.frbatlanta.org/filelegacydocs/erq407_mengle.pdf |format=PDF |accessdate=April 2, 2010 }}</ref>
<span style="color: red">Follow this [https://en.wikipedia.org/wiki/Special:Preferences#mw-prefsection-rendering link] to change your Math rendering settings.</span> You can also add a [https://en.wikipedia.org/wiki/Special:Preferences#mw-prefsection-rendering-skin Custom CSS] to force the MathML/SVG rendering or select different font families. See [https://www.mediawiki.org/wiki/Extension:Math#CSS_for_the_MathML_with_SVG_fallback_mode these examples].


Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency.<ref name="SimkovicSecret">Simkovic, Michael, [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1323190 "Secret Liens and the Financial Crisis of 2008"].</ref> A CDS can be unsecured (without collateral) and be at higher risk for a default.
==Demos==


==Description==
Here are some [https://commons.wikimedia.org/w/index.php?title=Special:ListFiles/Frederic.wang demos]:
{{Multiple image|direction=vertical|align=right|image1=Cds paymentstream protection noloss.svg|image2=Cds paymentstream protection loss event.svg|width=180|caption1=Buyer purchased a CDS at time t<sub>0</sub> and makes regular premium payments at times t<sub>1</sub>, t<sub>2</sub>, t<sub>3</sub>, and t<sub>4</sub>. If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t<sub>5</sub>, t<sub>6</sub> and so on until the end of the contract at time t<sub>n</sub>.|caption2=However, if the associated credit instrument suffered a credit event at t<sub>5</sub>, then the seller pays the buyer for the loss, and the buyer would cease paying premiums to the seller.}}


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 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.<ref name='Deutsche Bank Report'>{{cite journal|title=Credit default swaps: Heading towards a more stable system|journal=Deutsche Bank Research: Current Issues |date=December 21, 2009|first=Christian|last=Weistroffer |author2=Deutsche Bank Research |volume= |issue= |pages= |url=http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000252032.pdf|format=PDF |accessdate=April 15, 2010}}</ref><ref name="International Swaps and Derivatives Association, Inc. ISDA">{{cite web |url=http://www.isda.org/educat/faqs.html |title=24. Product description: Credit default swaps |author=International Swaps and Derivatives Association, Inc. (ISDA)
|accessdate=March 26, 2010 |quote=ISDA is the trade group that represents participants in the privately negotiated derivatives industry }}</ref>


A default is often referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower's [[credit rating]].<ref name="Deutsche Bank Report"/> CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and acceleration.<ref name='IMF254'/> Most CDSs are in the $10–$20&nbsp;million range<ref name='FRB Primer'>{{cite journal|title=Did You Know? A Primer on Credit Default Swaps|journal=Financial update|date=April 14, 2008|first=|last=Federal Reserve Bank of Atlanta|volume=21|issue=2|pages=|url=http://www.frbatlanta.org/pubs/financialupdate/financial_update-vol_21_no_2-did_you_know.cfm?redirected=true|format=|accessdate=March 31, 2010 }}</ref> with maturities between one and 10 years. Five years is the most typical maturity.<ref name='Mengle Overview' />
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** Orca: There is ongoing work, but no support at all at the moment [[File:Orca-mathml-example-1.wav|thumb|Orca-mathml-example-1]], [[File:Orca-mathml-example-2.wav|thumb|Orca-mathml-example-2]], [[File:Orca-mathml-example-3.wav|thumb|Orca-mathml-example-3]], [[File:Orca-mathml-example-4.wav|thumb|Orca-mathml-example-4]], [[File:Orca-mathml-example-5.wav|thumb|Orca-mathml-example-5]], [[File:Orca-mathml-example-6.wav|thumb|Orca-mathml-example-6]], [[File:Orca-mathml-example-7.wav|thumb|Orca-mathml-example-7]].
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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 derivative|credit insurance]], although CDS 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” allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity.<ref name='Sirri Testimony'>{{cite web|url=http://www.sec.gov/news/testimony/2008/ts101508ers.htm |title=Testimony Concerning Credit Default Swas Before the House Committee on Agriculture October 15, 2008 |accessdate=April 2, 2010 |last=Sirri |first=Erik, Director, Division of Trading and Markets U.S. Securities and Exchange Commission }}</ref>  Naked CDS constitute most of the market in CDS.<ref name="kopecki1">{{cite news | first=Dawn | last=Kopecki |author2=Shannon D. Harrington |authorlink= | title=Banning ‘Naked’ Default Swaps May Raise Corporate Funding Costs | date=July 24, 2009 | url =http://www.bloomberg.com/apps/news?pid=20601208&sid=a0W1VTiv9q2A |publisher=Bloomberg  | pages = | accessdate = March 31, 2010 | language = }}</ref><ref name='Salon'>{{cite news | first=Andrew | last=Leonard |authorlink= | title=Credit default swaps: What are they good for? | date=April 20, 2010 | publisher=Salon Media Group | url =http://www.salon.com/technology/how_the_world_works/2010/04/20/naked_credit_default_swaps | work =Salon.com | pages = | accessdate = April 24, 2010 | language = }}</ref>  In addition, CDSs can also be used in capital structure [[arbitrage]].
==Test pages ==


A "credit default swap" (CDS) is a [[credit derivative]] contract between two [[counterparty|counterparties]].  The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument [[default (finance)|defaults]] or experiences a similar [[credit event]].<ref name="Deutsche Bank Report"/><ref name="International Swaps and Derivatives Association, Inc. ISDA"/><ref>CFA Institute. (2008). ''Derivatives and Alternative Investments.'' pg G-11. Boston: Pearson Custom Publishing. ISBN 0-536-34228-8.</ref> The CDS may refer to a specified loan or bond obligation of a “reference entity”, usually a corporation or government.<ref name="FRB Primer"/>
To test the '''MathML''', '''PNG''', and '''source''' rendering modes, please go to one of the following test pages:
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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.
*[[Inputtypes|Inputtypes (private Wikis only)]]
 
*[[Url2Image|Url2Image (private Wikis only)]]
If the investor actually owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a [[hedge (finance)|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|Uses]]).
==Bug reporting==
 
If you find any bugs, please report them at [https://bugzilla.wikimedia.org/enter_bug.cgi?product=MediaWiki%20extensions&component=Math&version=master&short_desc=Math-preview%20rendering%20problem Bugzilla], or write an email to math_bugs (at) ckurs (dot) de .
If the reference entity (i.e., Risky Corp) defaults, one of two kinds of [[#Settlement|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 point]]s, or 0.5% (1 basis point = 0.01%), then an investor buying $10&nbsp;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.<ref name='Deutsche Bank Report' />
 
===Differences from insurance===
CDS contracts have obvious similarities with insurance, 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 (finance)|security]] and does not even have to suffer a loss from the default event.<ref>Cox, Christopher, Chairman, U.S. Securities and Exchange Commission. [http://www.sec.gov/news/testimony/2008/ts092308cc.htm "Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions"]. Senate Committee on Banking, Housing, and Urban Affairs. September 23, 2008. Retrieved March 17, 2009.</ref><ref>{{cite web|first=Mark |last=Garbowski |title=United States: Credit Default Swaps: A Brief Insurance Primer |url=http://www.mondaq.com/article.asp?articleid=68548 |quote=like insurance insofar as the buyer collects when an underlying security defaults ... unlike insurance, however, in that the buyer need not have an "insurable interest" in the underlying security |date=October 24, 2008 |accessdate=November 3, 2008}}</ref><ref>{{cite web|first=Gretchen |last=Morgenson |title=Credit default swap market under scrutiny |url=http://www.iht.com/articles/2008/08/10/business/morgen11.php |quote=If a default occurs, the party providing the credit protection&nbsp;— the seller&nbsp;— must make the buyer whole on the amount of insurance bought. |date=August 10, 2008 |accessdate=November 3, 2008}}</ref><ref>{{cite web|first=Karel|last= Frielink |title=Are credit default swaps insurance products? |url=http://www.curacao-law.com/2008/06/17/credit-default-swaps-and-insurance-issues-under-dutch-caribbean-law/ |quote=If the fund manager acts as the protection seller under a CDS, there is some risk of breach of insurance regulations for the manager.... There is no Netherlands Antilles case law or literature available which makes clear whether a CDS constitutes the ‘conducting of insurance business’ under Netherlands Antilles law. However, if certain requirements are met, credit derivatives do not qualify as an agreement of (non-life) insurance because such an arrangement would in those circumstances not contain all the elements necessary to qualify it as such. |date=August 10, 2008 |accessdate=November 3, 2008}}</ref> 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 [[Collateralized debt obligation|CDO]]s 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 reserving|loss reserves]] based on the [[Law of large numbers]] and [[Actuarial science|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 (finance)|volatility]] while insurance contracts are not;
* [[Hedge accounting]] may not be available under US [[Generally Accepted Accounting Principles]] (GAAP) unless the requirements of [http://www.fasb.org/st/summary/stsum133.shtml FAS 133] 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]]:<ref name="Deutsche Bank Report"/><ref name="Mengle Overview"/><ref>http://chicagofed.org/webpages/publications/understanding_derivatives/index.cfm</ref>
* 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 important, a seller normally limits its risk by buying offsetting protection from another party&nbsp;— 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 (finance)|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 derivative, 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 (finance)|collateral]]. The required collateral is agreed on by the parties when the CDS is first issued. This [[margin (finance)|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.").<ref name='kramer'>{{cite web|url=http://www.law.harvard.edu/programs/about/pifs/llm/select-papers-from-the-seminar-in-international-finance/llm-papers-2009-2010/kramer.pdf |title=Do We Need Central Counterparty Clearing of Credit Default Swaps?|date=April 20, 2010 |accessdate=April 3, 2011 |last=Kramer |first=Stefan|format=PDF }}</ref>
 
Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk.<ref name="Deutsche Bank Report"/> 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.<ref name='Gensler'>{{cite web|url=http://www.cftc.gov/ucm/groups/public/@newsroom/documents/speechandtestimony/opagensler-32.pdf |title=Keynote Address of Chairman Gary Gensler, OTC Derivatives Reform, Markit’s Outlook for OTC Derivatives Markets Conference|date=March 9, 2010 |accessdate=April 25, 2010 |last=Gensler |first=Gary, Chairman Commodity Futures Trading Commission|format=PDF }}{{Dead link|date=August 2010}}</ref> This risk is not present in other over-the-counter derivatives.<ref name="Deutsche Bank Report"/><ref name="Gensler"/>
 
===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<ref>{{cite web|url=http://www.isda.org/statistics/ |title=Surveys & Market Statistics |accessdate=April 20, 2010 |publisher=International Swaps and Derivatives Association (ISDA) }}</ref> and from the Bank for International Settlements (BIS) since 2004.<ref>{{cite web|url=http://www.bis.org/publ/otc_hy0112.htm |title=Regular OTC Derivatives Market Statistics |accessdate=April 20, 2010 |publisher=Bank for International Settlements }}</ref>  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.<ref>{{cite web|url=http://www.dtcc.com/products/derivserv/data/index.php |title=Trade Information Warehouse Reports |accessdate=April 20, 2010 |publisher=Depository Trust & Clearing Corporation (DTCC) }}</ref>  The numbers provided by each source do not always match because each provider uses different sampling methods.<ref name='Deutsche Bank Report' />
 
According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for virtually all CDS contracts outstanding in the marketplace."<ref>{{cite web|url=http://dtcc.com/products/derivserv/suite/ps_index.php |title=The Trade Information Warehouse (Warehouse) is the market's first and only centralized global repository for trade reporting and post-trade processing of OTC credit derivatives contracts |accessdate=April 23, 2010 |publisher=Depository Trust & Clearing Corporation }}</ref>
 
The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S commercial banks and trust companies.<ref>{{cite web|url=http://www.occ.treas.gov/deriv/deriv.htm |title=Publications: OCC's Quarterly Report on Bank Derivatives Activities |accessdate=April 20, 2010 |publisher=Office of the Comptroller of the Currency }}</ref>
 
==Uses==
Credit default swaps can be used by investors for [[speculation]], [[hedge (finance)|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 trading|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 (finance)|long]]” on the CDS and the credit, as if the investor owned the bond.<ref name='Sirri Testimony' /><ref name="Mengle Overview"/> In contrast, the investor who bought protection is “[[short (finance)|short]]” on the  CDS and the underlying credit.<ref name="Sirri Testimony"/><ref name="Mengle Overview"/>
 
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]].<ref name='CDO-Lucas'>{{cite book | last = Lucas | first = Douglas | authorlink = |author2=Laurie S. Goodman |author3=Frank J. Fabozzi  | title = Collateralized Debt Obligations: Structures and Analysis, 2nd Edition | publisher = John Wiley & Sons Inc. | date = May 5, 2006 | location = | page = 221| url = | doi = | isbn = 978-0-471-71887-1 }}</ref> Shorting a bond faced difficult practical problems, such that shorting was often not feasible; CDS made shorting credit possible and popular.<ref name="Mengle Overview"/><ref name='CDO-Lucas' />  Because the speculator in either case does not own the bond, its position is said to be a  synthetic long or short position.<ref name="Sirri Testimony"/>
 
For example, a [[hedge fund]] believes that Risky Corp will soon default on its debt. Therefore, it buys $10&nbsp;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&nbsp;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&nbsp;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&nbsp;million, without any return, thereby making a loss.  AAA-Bank, by selling protection, has made $1&nbsp;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&nbsp;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&nbsp;million = $1&nbsp;million, but receives 1 * 15% * $10&nbsp;million = $1.5&nbsp;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&nbsp;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&nbsp;million = $1&nbsp;million, but receives 1 * 2.5% * $10&nbsp;million = $250,000, giving a total loss of $750,000. This loss is smaller than the $1&nbsp;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 obligation]]s (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.<ref name="Partnoy Article"/> 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.<ref>{{cite news | first= | last= |authorlink= | title=SEC charges Goldman Sachs with fraud in subprime case | date=April 16, 2010 | publisher= | url =http://www.usatoday.com/money/companies/regulation/2010-04-16-goldman-sec-charges_N.htm | work =USA Today | pages = | accessdate = April 27, 2010 | language = }}</ref>  Abacus is a synthetic CDO consisting of credit default swaps referencing a variety of [[Mortgage-backed security|mortgage-backed securities]].
 
====Naked credit default swaps====
{{Anchor|naked credit default swap}}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.<ref name="kopecki1"/><ref name="Salon" /> 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.<ref name="Salon" />
 
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.<ref name="Brookings Paper">{{cite web |url=http://www.brookings.edu/~/media/Files/rc/papers/2010/0407_derivatives_litan/0407_derivatives_litan.pdf |title=The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties |accessdate=April 15, 2010 |last=Litan |first=Robert E. |date=April 7, 2010 |format=PDF |publisher=Brookings Institution }}</ref><ref name="Buiter">{{cite web |url=http://blogs.ft.com/maverecon/2009/03/should-you-be-able-to-sell-what-you-do-not-own/ |title=Should you be able to sell what you do not own? |accessdate=April 25, 2010 |last=Buiter |first=Willem |date=March 16, 2009 |work=Financial Times  }}</ref><ref>{{cite web|url=http://www.ft.com/cms/s/0/7b56f5b2-24a3-11df-8be0-00144feab49a.html |title=Time to outlaw naked credit default swaps |accessdate=April 24, 2010 |last=Munchau |first=Wolfgang |work=Financial Times}}</ref> Short selling is also viewed as gambling and the CDS market as a casino.<ref name="Salon" /><ref name="Leopold2009">{{cite book |first=Les|last= Leopold |title=The Looting of America: How Wall Street's Game of Fantasy Finance Destroyed Our Jobs, Our Pensions, and Prosperity, and What We Can Do About It |url=http://books.google.com/?id=oS7I_Pq00IQC&pg=PA221|accessdate=April 24, 2010 |date=June 2, 2009 |publisher=Chelsea Green Publishing |isbn=978-1-60358-205-6}}</ref>
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.<ref name="IMF254" /><ref name="Buiter" />  As a result, the risk of default is magnified leading to concerns about systemic risk.<ref name="Buiter" />
 
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.<ref name="Soros">{{cite news |first=George |last=Soros |authorlink= |title=Opinion: One Way to Stop Bear Raids |date=March 24, 2009 |publisher= |url=http://online.wsj.com/article/SB123785310594719693.html |work=Wall Street Journal |pages= |accessdate=April 24, 2010 |language = }}</ref> His concerns were echoed by several European politicians who, during the [[Economy of Greece#2010 debt crisis|Greek Financial Crisis]], accused naked CDS buyers of making the crisis worse.<ref name="Crackdown">{{cite news |first=Ben |last=Moshinsky |author2=Aaron Kirchfeld |authorlink= |title=Naked Swaps Crackdown in Europe Rings Hollow Without Washington |date=March 11, 2010 |publisher=Bloomberg |url=http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aj9Qo2YqmFKs |pages = |accessdate=April 24, 2010 |language = }}</ref><ref name="Greek">{{cite news |first=Stevenson |last=Jacobs |authorlink= |title=Greek Debt Crisis Is At The Center Of The Credit Default Swap Debate |date=March 10, 2010 |publisher= |url=http://www.huffingtonpost.com/2010/03/10/greek-pm-george-papandreo_n_493036.html |work=Huffington Post |pages= |accessdate=April 24, 2010 |language=}}</ref>
 
Despite these concerns, Secretary of Treasury Geithner<ref name="Salon" /><ref name="Crackdown" /> and [[Commodity Futures Trading Commission]] Chairman Gensler<ref>{{cite news | first= | last= |authorlink= | title=E.U. Derivatives Ban Won’t Work, U.S. Says | date=March 17, 2010 | publisher= | url =http://dealbook.blogs.nytimes.com/2010/03/17/u-s-warns-eu-derivatives-ban-wont-work/ | work =New York Times | pages = | accessdate = April 24, 2010 | language = }}</ref> are not in favor of an outright ban on naked credit default swaps. They prefer greater transparency and better capitalization requirements.<ref name="Salon" /><ref name="Gensler"/> 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.<ref name="Brookings Paper" /> That benefits hedging activities. Without speculators buying and selling naked CDSs, banks wanting to hedge might not find a ready seller of protection.<ref name="Salon" /><ref name="Brookings Paper" /> 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.<ref name="Brookings Paper" /><ref name="Short">{{cite journal |title=Short Selling |journal=Research Briefing |date=March 17, 2010 |first=Steffen|last=Kern |author2=Deutsche Bank Research |volume= |issue= |pages= |url=http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000255171.pdf |format=PDF |accessdate=April 24, 2010 }}</ref>
 
Despite assertions{{Citation needed|date=November 2011}} that speculators are making the Greek crisis worse, Germany's market regulator BaFin found no proof supporting the claim.<ref name="Greek" /> Some suggest{{Citation needed|date=November 2011}} that without credit default swaps, Greece’s borrowing costs would be higher.<ref name="Greek" /> As of November 2011, the Greek bonds have a bond yield of 28%.<ref>{{cite news|url=http://www.bloomberg.com/quote/GGGB10YR:IND |title=Greece Govt Bond 10 Year Acting as Benchmark|publisher=Bloomberg.com |date=March 8, 2012 |accessdate=March 12, 2012}}</ref>
 
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.<ref>{{cite web|url=http://www.govtrack.us/congress/bill.xpd?bill=h111-977 |title=Bill H.R. 977 |publisher=govtrack.us |accessdate=March 15, 2011}}</ref>
 
===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.<ref name="FRB Primer"/>
 
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 [[participation loan|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.<ref name="Partnoy Article"/>
 
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.<ref name="Partnoy Article"/> 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.<ref name="Partnoy Article"/>
 
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.<ref name="Deutsche Bank Report"/>  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.<ref name="Mengle Overview"/><ref name="FRB Primer"/><ref name='OCC Bulletin 96-43'>{{cite web|url=http://www.occ.treas.gov/ftp/bulletin/96-43.txt |title=OCC 96-43; OCC Bulletin; Subject: Credit Derivatives; Description: Guidelines for National Banks |accessdate=April 8, 2010 |date=August 12, 1996 |format=txt |publisher=Office of the Comptroller of the Currency }}</ref>
 
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.<ref name="Deutsche Bank Report"/><ref name='Arriva'>{{cite web|url=http://www.derivativesstrategy.com/magazine/archive/1997/1296fea1.asp |title=The Long Awaited Arrival of Credit Derivatives |accessdate=April 8, 2010 |last=McDermott |first=Robert |date=December/January 1997 |work=Derivatives Strategy }}</ref>
 
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&nbsp;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&nbsp;million.  The CDS trades at 200 [[basis point]]s (200 basis points = 2.00 percent).  In return for this credit protection, the pension fund pays 2% of $10&nbsp;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&nbsp;million back after five years from Risky Corp. Though the protection payments totaling $1&nbsp;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&nbsp;million minus recovery (either by physical or cash settlement&nbsp;— see Settlement [[#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&nbsp;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.<ref name='Salon' /><ref name='Brookings Paper' /><ref name='Arriva' /><ref>{{cite journal|title=Using Letters Of Credit, Credit Default Swaps And Other Forms of Credit Enhancements in Net Lease Transactions|journal=Virginia Law & Business Review|date=Spring 2009|first=Ken|last=Miller|volume=4|issue=1|pages=69–78, 80|url=http://www.virginialawbusrev.org/VLBR4-1pdfs/Miller.pdf|format=|accessdate=April 15, 2010|quote=  the use of an exotic credit default swap (called a Net Lease CDS), which effectively hedges tenant credit risk but at a substantially higher price than a vanilla swap.}}</ref>
 
Although credit default swaps have been highly criticized for their role in the recent [[Financial crisis of 2007–2010|financial crisis]], most observers conclude that using credit default swaps  as a hedging device has a useful purpose.<ref name='Brookings Paper' />
 
===Arbitrage===
''Capital Structure Arbitrage'' is an example of an [[arbitrage]] strategy that utilizes CDS transactions.<ref>[http://cisdm.som.umass.edu/research/pdffiles/Capital%20Structure%20Manolis%20Chatiras.pdf] Chatiras, Manolis, and Barsendu Mukherjee. ''Capital Structure Arbitrage: Investigation using Stocks and High Yield Bonds''. Amherst, MA: Center for International Securities and Derivatives Markets, Isenberg School of Management, University of Massachusetts, Amherst, 2004. Retrieved March 17, 2009.</ref> 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.  Misalignments 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 can aim to exploit any differences to make risk-free profit.
 
==History==
 
===Conception===
Forms of credit default swaps had been in existence from at least the early 1990s,<ref name=smithson>{{cite journal |title=The Promise of Credit Derivatives in Nonfinancial Corporations (and Why It’s Failed to Materialize) |journal=''[[Journal of Applied Corporate Finance]]'' (Morgan Stanley)|date=Fall 2006 |first=Charles |last=Smithson |author2=David Mengle |volume=18 |issue=4 |pages=54–60 |url=http://www.rutterassociates.com/pdf/Promise%20of%20Credit%20Derivatives%20in%20Nonfinancial%20Corporations%20%28JACF%202006%29.pdf |format=PDF |accessdate=April 8, 2010}}</ref> with early trades carried out by [[Bankers Trust]] in 1991.<ref name="FoolsGold">
{{cite book
|authorlink=Gillian Tett|first=Gillian|last= Tett
|title=Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe
|year=2009
|pages = 48–67, 87,  303
|isbn=978-0-349-12189-5
|publisher=Little Brown
}}</ref> [[J.P. Morgan & Co.]] is widely credited with creating the modern credit default swap in 1994.<ref name="Philips">{{cite news |first=Matthew |last=Philips |authorlink= | title=The Monster That Ate Wall Street |date=September 27, 2008 |publisher= |url=http://www.newsweek.com/id/161199 |work=Newsweek |pages= |accessdate=April 7, 2010 |language = }}</ref><ref>{{cite news |first=John |last=Lanchester |authorlink= |title=Outsmarted |date=June 1, 2009 |publisher= |url=http://www.newyorker.com/arts/critics/books/2009/06/01/090601crbo_books_lanchester |work=New Yorker |pages= |accessdate=April 7, 2010 |language = }}</ref><ref name="Tett, Gillian 2006">Tett, Gillian. [http://www.ft.com/cms/s/2/7886e2a8-b967-11da-9d02-0000779e2340.html?nclick_check=1 “The Dream Machine: Invention of Credit Derivatives"]. ''Financial Times''. March 24, 2006. Retrieved March 17, 2009.</ref> In that instance, J.P. Morgan had extended a $4.8&nbsp;billion credit line to [[Exxon]], which faced the threat of $5&nbsp;billion in [[punitive damages]] for the [[Exxon Valdez oil spill]]. A team of J.P. Morgan bankers led by [[Blythe 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.<ref>{{cite news |first=John |last=Lanchester |authorlink= |title=Outsmarted |date=June 1, 2009 |publisher= |url=http://www.newyorker.com/arts/critics/books/009/06/01/090601crbo_books_lanchester |work=New Yorker |pages= |accessdate=April 7, 2010 |language= }}{{Dead link|date=August 2010}}</ref>
 
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.<ref name="Philips"/><ref name="Tett, Gillian 2006"/>  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&nbsp;billion in credit risk all at once. BISTRO was the first example of what later became known as synthetic [[collateralized debt obligation]]s (CDOs).
 
Mindful of the concentration of default risk as one of the causes of the [[Savings and loan crisis|S&L crisis]], regulators initially found CDS's ability to disperse default risk attractive.<ref name="FoolsGold"/>
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]],<ref name="IMF254" /> specifically stated that CDSs are neither futures nor securities and so are outside the remit of the SEC and CFTC.<ref name="FoolsGold"/>
 
===Market growth===
At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in connection with its lending activities.  Banks also saw an opportunity to free up regulatory capital. By March 1998, the global market for CDS was estimated at about $300 billion, with JP Morgan alone accounting for about $50 billion of this.<ref name = "FoolsGold"/>
 
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.<ref name="Deutsche Bank Report"/><ref name="Mengle Overview"/><ref name="Arriva"/><ref name=smithson/>
National banks in the USA used credit default swaps as early as 1996.<ref name='OCC Bulletin 96-43' />  In that year, the Office of the Comptroller of the Currency measured the size of the market as tens of billions of dollars.<ref>{{cite news | first=Ellen | last=Simon |authorlink= | title=Meltdown 101: What are credit default swaps? | date=October 20, 2008 | publisher= | url =http://www.usatoday.com/money/economy/2008-10-20-2778456512_x.htm | work =USA Today | pages = | accessdate = April 7, 2010 | language = }}</ref>  Six years later, by year-end 2002, the outstanding amount was over $2&nbsp;trillion.<ref name='ISDA Annual Chart' />
 
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.<ref>{{cite web|url=http://www.federalreserve.gov/boarddocs/speeches/2005/20050505/default.htm |title=Remarks by Chairman Alan Greenspan Risk Transfer and Financial Stability To the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago, Illinois (via satellite) May 5, 2005 |accessdate=April 8, 2010 |date=May 5, 2005 |publisher=Federal Reserve Board }}</ref><ref>{{cite web|url=http://www.derivativesstrategy.com/magazine/archive/1997/1296fea1.asp |title=The Long Awaited Arrival of Credit Derivatives |accessdate=April 8, 2010 |last=McDermott |first=Robert |date=December/January 1997 |work=Derivatives Strategy| quote= The lack of standardized documentation for credit swaps, in fact, could become a major brake on market expansion. }}</ref><ref name='Ranciere IMF Paper'>{{cite journal|title=Credit Derivatives in Emerging Markets|journal=IMF Policy Discussion Paper|date=April 2002|first=Romain G.|last=Ranciere|volume=|issue=|pages=|url=http://www.crei.cat/people/ranciere/wpapers/imf.pdf|format=PDF|accessdate=April 8, 2010 }}</ref> Also, the [[1997 Asian Financial Crisis]] spurred a market for CDS in emerging market sovereign debt.<ref name='Ranciere IMF Paper' /> In addition, in 2004, index trading began on a large scale and grew rapidly.<ref name="Mengle Overview"/>
 
The market size for Credit Default Swaps more than doubled in size each year from $3.7&nbsp;trillion in 2003.<ref name="ISDA Annual Chart"/>  By the end of 2007, the CDS market had a notional value of $62.2&nbsp;trillion.<ref name="ISDA Annual Chart"/> 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&nbsp;trillion.<ref>{{cite web|url=http://www.isda.org/index.html |title=ISDA Market Survey, Year-End 2008 |publisher=Isda.org |accessdate=August 27, 2010}}</ref>
 
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.<ref>{{cite news | first=Riva D. | last=Atlas |authorlink= | title=Trying to Put Some Reins on Derivatives | date=September 16, 2005 | publisher= | url =http://www.nytimes.com/2005/09/16/business/16credit.html?_r=1 | work =New York Times | pages = | accessdate = April 8, 2010 | language = }}</ref> This created severe risk management issues, as counterparties were in legal and financial limbo.<ref name="Mengle Overview"/><ref>{{cite journal|title=Credit Derivatives, Macro Risks, and Systemic Risks|journal=Economic Review (FRB Atlanta)|date=Fourth Quarter 2007|first=Tim|last=Weithers|volume=92|issue=4|pages=43–69|url=http://www.frbatlanta.org/filelegacydocs/erq407_weithers.pdf|format=PDF|accessdate=April 9, 2010 }}</ref> U.K. authorities expressed the same concerns.<ref>{{cite web|url=http://www.fsa.gov.uk/pubs/plan/financial_risk_outlook_2006.pdf |title=The level of outstanding credit-derivative trade confirmations presents operational and legal risks for firms |accessdate=April 8, 2010 |format=PDF |work=Financial Risk Outlook 2006 |publisher=The Financial Services Authority }}</ref>
 
===Market as of 2008===
[[File:Credit default swaps by quality size coloured sp percent years.png|thumb|Composition of the United States 15.5&nbsp;trillion US dollar CDS market at the end of 2008 Q2. Green tints show Prime asset CDSs, reddish tints show sub-prime asset CDSs. Numbers followed by "Y" indicate years until maturity.]]
[[File:Credit default swaps vs total nominals plus debt.png|thumb|Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in 2008Q2. The black disc represents the 2008 public debt.]]
 
Since default is a relatively rare occurrence (historically around 0.2% of investment grade companies default in any one year),<ref>{{cite web|url=http://www.efalken.com/banking/html's/defaultcurves.htm |title=Default Rates |publisher=Efalken.com |accessdate=August 27, 2010}}</ref> 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====
The market for Credit Default Swaps attracted considerable concern from regulators after a number of large scale incidents in 2008, starting with the [[collapse of Bear Stearns]].<ref name="Colin Barr">{{cite news
|url= http://money.cnn.com/2009/03/16/markets/cds.bear.fortune/index.htm
|title= The truth about credit default swaps
|publisher= CNN / Fortune
|author= Colin Barr
|accessdate=March 27, 2009
| date=March 16, 2009}}</ref>
 
In the days and weeks leading up to Bear's collapse, the bank's 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 [[JPMorgan Chase|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&nbsp;billion to become payable to the buyers of CDS protection referenced against the insolvent bank.{{Citation needed|date=January 2012}}  However the net amount that changed hands was around $7.2&nbsp;billion.{{Citation needed|date=January 2012}}<ref>{{cite web |url=http://www.ft.com/cms/s/0/25137702-972d-11dd-8cc4-000077b07658.html |title= Bad news on Lehman CDS |publisher=Ft.com |date=October 11, 2008 |accessdate=August 27, 2010}}</ref> ([[The given citation does not support either of the two purported facts stated in previous two sentences.]]). 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{{citation needed|date=September 2012}} a federal bailout 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&nbsp;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.<ref name="Colin Barr"/> 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.
 
In 2008 there was no centralized [[Exchange (organized market)|exchange]] or [[Clearing house (finance)|clearing house]] for CDS transactions; they were all done [[Over-the-counter (finance)|over the counter]] (OTC). This led to recent calls for the market to open up in terms of transparency and regulation.<ref>{{cite web |url=http://www.sec.gov/news/testimony/2008/ts092308cc.htm |title=Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions (Christopher Cox, September 23, 2008) |publisher=Sec.gov |date=September 23, 2008 |accessdate=August 27, 2010}}</ref>
 
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,<ref>{{cite news |url=http://www.guardian.co.uk/business/2008/nov/05/creditcrunch-marketturmoil |work=The Guardian |location=London |title=Banks hit back at derivatives criticism |first=Simon |last=Bowers |date=November 5, 2008 |accessdate=April 30, 2010}}</ref> announced that it will release market data on the outstanding notional of CDS trades on a weekly basis.<ref>{{cite news|last=Harrington |first=Shannon D. |url=http://www.bloomberg.com/apps/news?pid=20601085&sid=aZYSaaTg9xJg&refer=europe |title=Credit-Default Swaps on Italy, Spain Are Most Traded (Update1) |publisher=Bloomberg |date=November 5, 2008 |accessdate=August 27, 2010}}</ref>  The data can be accessed on the DTCC's website here:<ref>{{cite web |url=http://www.dtcc.com/products/derivserv/data/index.php?lpos=home_splash_promo&lid=index.php |title=DTCC " DTCC Deriv/SERV Trade Information Warehouse Reports |publisher=Dtcc.com |accessdate=August 27, 2010}}</ref>
 
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).<ref name=businessweek1>
{{cite web
|url=http://www.businessweek.com/magazine/content/10_32/b4190056333791.htm
|publisher=Bloomberg Business Week
|title=ICE's Jeffrey Sprecher: The Sultan of Swaps
|author=Chad Terhune
|date=July 29, 2010
|accessdate=February 15, 2013
}}</ref>  <ref group=notes>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).</ref> 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).<ref name=businessweek1 /> 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).<ref name=businessweek1 /> (Litan Derivatives Dealers’ Club 2010)." <ref name=Litan>{{cite web
|title=The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties
|author=Robert E. Litan
|url=http://www.brookings.edu/~/media/research/files/papers/2010/4/07%20derivatives%20litan/0407_derivatives_litan.pdf
|format=PDF
|date=April 7, 2010
|publisher=[[Brookings Institute]]
}}</ref> 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)." <ref name=Litan /> 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)." <ref name=Litan />
 
In 2009 the U.S. Securities and Exchange Commission granted an exemption for [[IntercontinentalExchange]] to begin guaranteeing credit-default swaps. The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental.<ref name=Bloomberg2009>{{cite news |url=http://articles.chicagotribune.com/2009-03-07/news/0903060305_1_intercontinentalexchange-exemption-credit-default |title=IntercontinentalExchange gets SEC exemption: The exchange will begin clearing credit-default swaps next week |date=March 7, 2009 |publisher=Bloomberg News }}</ref> 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".<ref name=Bloomberg2009 /> IntercontinentalExchange's subsidiary, ICE Trust's larger competitor, [[CME Group|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&nbsp;trillion.<ref name="Aline Van Duyn">{{cite web
|url= http://www.ft.com/cms/s/0/af1efb78-0dc6-11de-8ea3-0000779fd2ac.html
|title= Worries Remain Even After CDS Clean-Up
|publisher= The Financial Times
|first= Aline |last=Van Duyn
|accessdate=March 12, 2009}}</ref>
 
The Bank for International Settlements estimates that outstanding derivatives total $708&nbsp;trillion.<ref>{{cite web
|url= http://www.bis.org/publ/otc_hy1111.pdf
|title= OTC derivatives market activity in the first half of 2011
|publisher= Bank for International Settlements
|author= Monetary and Economic Department
|accessdate=Dec 15, 2011}}
</ref> 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,<ref name=Bloomberg2009 /> one of the backers for IntercontinentalExchange's subsidiary, ICE Trust in New York, launched in 2008, claimed that {{cquote|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&nbsp;billion reducing the open interest down to EUR 75&nbsp;billion<ref name="Report Center - Data">{{cite web|url=https://www.theice.com/marketdata/reports/ReportCenter.shtml?reportId=98 |title=Report Center - Data |publisher=ICE |accessdate=March 12, 2012}}</ref>
 
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.<ref name = "FoolsGold"/><ref name="Report Center - Data"/>
 
====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&nbsp;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 {{cquote| 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.<ref>{{cite news
|url= http://www.bloomberg.com/apps/news?pid=20601087&sid=afJz1FLOy1nI&refer=home
|title= Intercontinental to Clear Credit Swaps Next Week
|publisher= Bloomberg
|first= Matthew |last=Leising|first2=Shannon D|last2= Harrington
|accessdate=March 12, 2009|date=March 6, 2009}}
</ref>
 
====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&nbsp;billion 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 for J.P. Morgan Chase & Co., 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.<ref>{{cite news| url=http://online.wsj.com/article/SB10001424052702303299604577326031119412436.html?mod=wsj_share_tweet | work=The Wall Street Journal | first1=Gregory | last1=Zuckerman | first2=Katy | last2=Burne | title='London Whale' Rattles Debt Market | date=April 6, 2012}}</ref><ref name=NYTLR>{{cite news|title=As One JPMorgan Trader Sold Risky Contracts, Another One Bought Them|url=http://dealbook.nytimes.com/2012/05/15/as-one-jpmorgan-trader-sold-risky-contracts-another-one-bought-them/|accessdate=May 16, 2012|newspaper=The New York Times|date=May 15, 2012|author=Azam Ahmed}}</ref> [[2012 JPMorgan Chase trading loss|Major losses]], $2 billion, 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,<ref name=WSJwaves>{{cite news|title=Making Waves Against 'Whale'|url=http://online.wsj.com/article/SB10001424052702304587704577336130953863286.html?KEYWORDS=making+waves|accessdate=May 16, 2012|newspaper=The Wall Street Journal|date=April 10, 2012|author=Katy Burne}}</ref><ref name=eFN>{{cite news|title=Chart of the Day: London Whale trading|url=http://www.efinancialnews.com/story/2012-05-11/jpmorgan-iksil-cds-hedgefunds|accessdate=May 16, 2012|newspaper=Financial News|date=May 11, 2012|author=Farah Khalique}}</ref> has been described as a "derivative of a derivative".<ref name=DNBlack>{{cite news|title=Crony Capitalism: After Lobbying Against New Financial Regulations, JPMorgan Loses $2B in Risky Bet|url=http://www.democracynow.org/2012/5/15/crony_capitalism_after_lobbying_against_new|accessdate=May 16, 2012|newspaper=Democracy Now!|date=May 15, 2012}}</ref><ref name=DealBook2B>{{cite news|title=JPMorgan Discloses $2 Billion in Trading Losses|url=http://dealbook.nytimes.com/2012/05/10/jpmorgan-discloses-significant-losses-in-trading-group/|accessdate=May 16, 2012|newspaper=The New York Times|date=May 10, 2012|author=Jessica Silver-Greenberg|author2=Peter Eavis}}</ref>
 
==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]].<ref>{{cite web|url=http://www.isda.org/publications/isdacredit-deri-def-sup-comm.aspx |title=2003 Credit Derivatives Definitions |publisher=Isda.org |accessdate=August 27, 2010}}</ref> 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 debt|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==
{{Main|Causes of the European sovereign-debt crisis}}
 
[[File:Sovereign credit default swaps.png|thumb|300px|right|Sovereign credit default swap prices of selected European countries (2010-2011). The left axis is basis points, or 100ths of a percent; a level of 1,000 means it costs $1 million per year to protect $10 million of debt for five years.]]
 
The European sovereign debt crisis resulted from a combination of complex factors, including the [[Financialization|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 bubble|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.<ref>{{cite web|url=http://www.eubusiness.com/news-eu/finance-economy-cds.dij|title=Euro-Parliament bans "naked" Credit Default Swaps|publisher=EUbusiness|date=Nov 16, 2011|accessdate=Nov 26, 2011}}</ref>
 
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 current 2012 negotiations regarding the restructuring of [[Greek sovereign debt]], one important issue is whether the restructuring will trigger Credit default swap (CDS) payments.  European Central Bank and the International Monetary Fund negotiators are trying to avoid these triggers as they may jeopardize the stability of major European banks who have been protection writers.  (An alternative would be to create new credit default swaps (CDS) which clearly would pay in the event of any Greek restructuring. The market could then price the spread between these and old (potentially more ambiguous) credit default swaps (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.<ref>[http://www.financewise.com/public/edit/riskm/credit/march01/story2.htm, Financewise.com]</ref>
 
==Settlement==
 
===Physical or cash===
As described in an earlier section, if a credit event occurs then CDS contracts can either be ''physically settled'' or ''cash settled''.<ref name="Deutsche Bank Report"/>
 
* 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&nbsp;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&nbsp;million cash, and the hedge fund must deliver $5&nbsp;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&nbsp;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.  Therefore, the bank must pay the hedge fund $5&nbsp;million * (100%-25%) = $3.75&nbsp;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.)  For example, at the time it filed for bankruptcy on September 14, 2008, Lehman Brothers had approximately $155&nbsp;billion of outstanding debt<ref>{{cite web|url=http://seekingalpha.com/article/99286-settlement-auction-for-lehman-cds-surprises-ahead |title=Settlement Auction for Lehman CDS: Surprises Ahead? |publisher=Seeking Alpha |date=October 10, 2008 |accessdate=August 27, 2010}}</ref> but around $400&nbsp;billion notional value of CDS contracts had been written that referenced this debt.<ref>{{cite web|url=http://www.ft.com/cms/s/0/7a268486-93cd-11dd-9a63-0000779fd18c,dwp_uuid=11f94e6e-7e94-11dd-b1af-000077b07658.html |title=In depth: Fed to hold CDS clearance talks |publisher=Ft.com |accessdate=August 27, 2010}}</ref>  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]].<ref name="isda.org">{{cite web|url=http://www.isda.org/press/press102108.html |title=Isda Ceo Notes Success Of Lehman Settlement, Addresses Cds Misperceptions |publisher=Isda.org |date=October 21, 2008 |accessdate=August 27, 2010}}</ref> 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 crisis#Fifth austerity package – February 2012|Greek government debt]].<ref>{{cite web|last=Salmon|first=Felix| url=http://seekingalpha.com/article/403341-how-greece-s-default-could-kill-the-sovereign-cds-market |title=How Greece's Default Could Kill The Sovereign CDS Market |publisher=[[Seeking Alpha]] |date=March 1, 2012 |accessdate=March 1, 2012}}</ref> For its part, ISDA in the leadup to a 50% or greater [[Haircut (finance)|"haircut"]] for Greek bondholders, issued an opinion that the bond swap would not constitute a default event.<ref>Watts, William L., [http://www.marketwatch.com/story/no-greek-cds-payout-on-swap-panel-says-2012-03-01 "No Greek CDS payout on swap, panel says"], ''[[MarketWatch]]'', March 1, 2012. Retrieved 2012-03-01.</ref>
 
Below is a list of the auctions that have been held since 2005.<ref>[[Markit Group Limited|Markit]]. [http://www.communicatorinc.com/information/affiliations/fixings.html Tradeable Credit Fixings]. Retrieved 2008-10-28.</ref>
 
{|class="wikitable sortable"
|-
!Date !! Name !! Final price as a percentage of [[Par value#Bonds|par]]
|-
|2005-06-14 ||[[Collins & Aikman]] - Senior||43.625
|-
|2005-06-23 ||[[Collins & Aikman]] - Subordinated||6.375
|-
|2005-10-11 ||[[Northwest Airlines]] || 28
|-
|2005-10-11 ||[[Delta Air Lines]] || 18
|-
|2005-11-04 || [[Delphi Corporation]] ||63.375
|-
|2006-01-17 || [[Calpine Corporation]] || 19.125
|-
|2006-03-31 || [[Dana Corporation]] || 75
|-
|2006-11-28 || [[Dura Automotive Systems|Dura]] - Senior|| 24.125
|-
|2006-11-28 || [[Dura Automotive Systems|Dura]] - Subordinated || 3.5
|-
|2007-10-23 || [[Movie Gallery]] || 91.5
|-
|2008-02-19 || [[Quebecor World]] || 41.25
|-
|2008-10-02 || [[Tembec Inc]] || 83
|-
|2008-10-06 ||[[Fannie Mae]] - Senior || 91.51
|-
|2008-10-06 ||[[Fannie Mae]] - Subordinated || 99.9
|-
|2008-10-06 ||[[Freddie Mac]] - Senior || 94
|-
|2008-10-06 ||[[Freddie Mac]] - Subordinated || 98
|-
|2008-10-10 ||[[Lehman Brothers]] || 8.625
|-
|2008-10-23 || [[Washington Mutual]] || 57
|-
|2008-11-04 || [[Landsbanki]] - Senior || 1.25
|-
|2008-11-04 || [[Landsbanki]] - Subordinated || 0.125
|-
|2008-11-05 || [[Glitnir (bank)|Glitnir]] - Senior || 3
|-
|2008-11-05 || [[Glitnir (bank)|Glitnir]] - Subordinated || 0.125
|-
|2008-11-06 || [[Kaupthing]] - Senior || 6.625
|-
|2008-11-06 || [[Kaupthing]] - Subordinated || 2.375
|-
|2008-12-09 || Masonite [http://www.masonite.com/] - LCDS || 52.5
|-
|2008-12-17 || [[Hawaiian Telcom]] - LCDS || 40.125
|-
|2009-01-06 || [[Tribune Company|Tribune]] - CDS || 1.5
|-
|2009-01-06 || [[Tribune Company|Tribune]] - LCDS || 23.75
|-
|2009-01-14 || [[Ecuador|Republic of Ecuador]] || 31.375
|-
|2009-02-03 || Millennium America Inc || 7.125
|-
|2009-02-03 || [[LyondellBasell|Lyondell]] - CDS || 15.5
|-
|2009-02-03 || [[LyondellBasell|Lyondell]] - LCDS || 20.75
|-
|2009-02-03 || EquiStar || 27.5
|-
|2009-02-05 || Sanitec [http://www.sanitec.com/] - 1st Lien || 33.5
|-
|2009-02-05 || Sanitec [http://www.sanitec.com/] - 2nd Lien || 4.0
|-
|2009-02-09 || British Vita [http://www.britishvita.com/] - 1st Lien|| 15.5
|-
|2009-02-09 || British Vita [http://www.britishvita.com/] - 2nd Lien|| 2.875
|-
|2009-02-10 || Nortel Ltd. || 6.5
|-
|2009-02-10 || Nortel Corporation || 12
|-
|2009-02-19 || Smurfit-Stone CDS || 8.875
|-
|2009-02-19 || Smurfit-Stone LCDS || 65.375
|-
|2009-02-26 || Ferretti || 10.875
|-
|2009-03-09 || Aleris|| 8
|-
|2009-03-31 || Station Casinos || 32
|-
|2009-04-14 || Chemtura || 15
|-
|2009-04-14 || Great Lakes|| 18.25
|-
|2009-04-15 || Rouse  || 29.25
|-
|2009-04-16 || LyondellBasell || 2
|-
|2009-04-17 || Abitibi|| 3.25
|-
|2009-04-21 || Charter Communications CDS || 2.375
|-
|2009-04-21 || Charter Communications LCDS|| 78
|-
|2009-04-22 || Capmark|| 23.375
|-
|2009-04-23 || Idearc CDS|| 1.75
|-
|2009-04-23 || Idearc LCDS|| 38.5
|-
|2009-05-12 || Bowater|| 15
|-
|2009-05-13 || General Growth Properties || 44.25
|-
|2009-05-27 || Syncora || 15
|-
|2009-05-28 || Edshcha|| 3.75
|-
|2009-06-09 || HLI Operating Corp LCDS || 9.5
|-
|2009-06-10 || Georgia Gulf LCDS || 83
|-
|2009-06-11 || R.H. Donnelley Corp. CDS || 4.875
|-
|2009-06-12 || General Motors CDS || 12.5
|-
|2009-06-12 || General Motors LCDS || 97.5
|-
|2009-06-18 || JSC Alliance Bank CDS || 16.75
|-
|2009-06-23 || Visteon CDS || 3
|-
|2009-06-23 || Visteon LCDS || 39
|-
|2009-06-24 || RH Donnelley Inc LCDS || 78.125
|-
|2009-07-09 || Six Flags CDS || 14
|-
|2009-07-09 || Six Flags LCDS || 96.125
|-
|2009-07-21 || Lear CDS || 38.5
|-
|2009-07-21 || Lear LCDS || 66
|-
|2009-11-10 || METRO-GOLDWYN-MAYER INC. LCDS || 58.5
|-
|2009-11-20 || CIT Group Inc. || 68.125
|-
|2009-12-09 || Thomson || 77.75
|-
|2009-12-15 || Hellas II || 1.375
|-
|2009-12-16 || NJSC Naftogaz of Ukraine || 83.5
|-
|2010-01-07 || Financial Guarantee Insurance Compancy (FGIC) || 26
|-
|2010-02-18 || CEMEX || 97.0
|-
|2010-03-25 || Aiful || 33.875
|-
|2010-04-15 || McCarthy and Stone || 70.375
|-
|2010-04-22 || Japan Airlines Corp || 20.0
|-
|2010-06-04 || Ambac Assurance Corp || 20.0
|-
|2010-07-15 || Truvo Subsidiary Corp || 3.0
|-
|2010-09-09 || Truvo (formerly World Directories) || 41.125
|-
|2010-09-21 || Boston Generating LLC || 40.75
|-
|2010-10-28 || Takefuji Corp || 14.75
|-
|2010-12-09 || Anglo Irish Bank || 18.25
|-
|2010-12-10 || Ambac Financial Group || 9.5
|-
|2011-11-29 || Dynegy Holdings, LLC || 71.25
|-
|2011-12-09 || Seat Pagine Gialle || 10.0
|-
|2011-12-13 || PMI Group || 16.5
|-
|2011-12-15 || AMR Corp || 23.5
|-
|2012-02-22 || Eastman Kodak Co || 22.875
|-
|2012-03-19 || Hellenic Republic || 21.75
|-
|2012-03-22 || Elpida Memory || 20.125
|-
|2012-03-29 || ERC Ireland Fin Ltd || 0.0
|-
|2012-05-09 || Sino Forest Corp || 29.0
|-
|2012-05-30 || Houghton Mifflin Harcourt Publishing Co || 55.5
|-
|2012-06-06 || Residential Cap LLC  || 17.625
|}
 
==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 C. Hull|John Hull]] and [[Alan White (economist)|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 (finance)|default]] events never occurred the price of a CDS would simply be the sum of the [[Discounted cash flow|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 <math>t_0</math> with four quarterly premium payments occurring at times <math>t_1</math>, <math>t_2</math>, <math>t_3</math>, and <math>t_4</math>. If the nominal for the CDS is <math>N</math> and the issue premium is <math>c</math> then the size of the quarterly premium payments is <math>Nc/4</math>. 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 <math>N(1-R)</math> shown in red, where <math>R</math> is the recovery rate, or it survives without a default being triggered, in which case a premium payment of <math>Nc/4</math> 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.
 
[[File:Cds cashflows.svg|Cashflows for a Credit Default Swap.]]
 
The probability of surviving over the interval <math>t_{i-1}</math> to <math>t_i</math> without a default payment is <math>p_i</math> and the probability of a default being triggered is <math>1-p_i</math>. The calculation of present value, given [[discount factor]] of <math>\delta_1</math> to <math>\delta_4</math> is then
 
{| class="wikitable"
|-
!|Description
!|Premium Payment PV
!|Default Payment PV
!|Probability
|-
|Default at time <math>t_1</math>
|<math>0\,</math>
|<math>N(1-R) \delta_1\,</math>
|<math>1-p_1\,</math>
|-
|Default at time <math>t_2</math>
|<math>-\frac{Nc}{4} \delta_1</math>
|<math>N(1-R) \delta_2\,</math>
|<math>p_1(1-p_2)\,</math>
|-
|Default at time <math>t_3</math>
|<math>-\frac{Nc}{4}(\delta_1 + \delta_2)</math>
|<math>N(1-R) \delta_3\,</math>
|<math>p_1 p_2 (1-p_3)\,</math>
|-
|Default at time <math>t_4</math>
|<math>-\frac{Nc}{4}(\delta_1 + \delta_2 + \delta_3)</math>
|<math>N(1-R) \delta_4\,</math>
|<math>p_1 p_2 p_3 (1-p_4)\,</math>
|-
|No defaults
|<math>-\frac{Nc}{4} ( \delta_1 + \delta_2 + \delta_3 + \delta_4 )</math>
|<math>0\,</math>
|<math>p_1 \times p_2 \times p_3 \times p_4</math>
|}
 
The probabilities <math>p_1</math>, <math>p_2</math>, <math>p_3</math>, <math>p_4</math> can be calculated using the [[credit spread (bond)|credit spread]] curve. The probability of no default occurring over a time period from <math>t</math> to <math>t+\Delta t</math> [[Exponential decay|decays exponentially]] with a time-constant determined by the credit spread, or mathematically <math>p=\exp(-s(t) \Delta t/(1-R))</math> where <math>s(t)</math> is the [[credit spread (bond)|credit spread]] zero curve at time <math>t</math>. 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
 
{|
|-
|<math>PV\,</math>
|<math>=\,</math>
|<math>(1 - p_1) N(1-R) \delta_1\,</math>
|-
|
|
|<math>+ p_1 ( 1 - p_2 ) [ N(1-R) \delta_2 - \frac{Nc}{4} \delta_1 ]</math>
|-
|
|
|<math>+p_1 p_2 ( 1 - p_3 ) [ N(1-R) \delta_3 - \frac{Nc}{4} (\delta_1 + \delta_2) ]</math>
|-
|
|
|<math>+p_1 p_2 p_3 (1 - p_4) [ N(1-R) \delta_4 - \frac{Nc}{4} (\delta_1 + \delta_2 + \delta_3) ]</math>
|-
|
|
|<math>-p_1 p_2 p_3 p_4 ( \delta_1 + \delta_2 + \delta_3 + \delta_4 ) \frac{Nc}{4}</math>
|}
 
===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.
 
Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a CDS contract should trade at 30. However there are sometimes technical reasons why this will not be the case, and this may or may not present an arbitrage opportunity for the canny investor. The difference between the theoretical model and the actual price of a credit default swap is known as the basis.
 
==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 [[Financial crisis of 2007–2008|2008 global financial crisis]] by hastening the demise of companies such as Lehman Brothers and [[American International Group|AIG]].<ref name="Philips"/>
 
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.<ref>{{cite news|url=http://dealbook.blogs.nytimes.com/2009/06/23/gannett-and-the-side-effects-of-default-swaps/| title=Gannett and the Side Effects of Default Swaps |date = June 23, 2009 | accessdate = July 14, 2009 | work=The New York Times}}</ref> Due to a lack of transparency, there was no way to identify the protection buyers and protection writers.<ref>{{cite web|url=http://firedoglake.com/2009/05/14/protecting-gm-from-credit-default-swap-holders/| title=Protecting GM from Credit Default Swap Holders |publisher=Firedoglake |date = May 14, 2009 | accessdate = July 14, 2009 }}</ref>
 
It was also feared at the time of Lehman's bankruptcy that the $400&nbsp;billion notional of CDS protection which had been written on the bank could lead to a net payout of $366&nbsp;billion from protection sellers to buyers (given the cash-settlement [[#Auctions|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.<ref name="ft.com">{{cite web|url=http://www.ft.com/cms/s/0/d96751f8-96f4-11dd-8cc4-000077b07658.html |title=/ Financials&nbsp;— Lehman CDS pay-outs higher than expected |publisher=Ft.com |date=October 10, 2008 |accessdate=August 27, 2010}}</ref>  However, industry estimates after the auction suggest that net cashflows were only in the region of $7&nbsp;billion.<ref name="ft.com"/> because many parties held offsetting positions.  Furthermore, CDS deals are [[Mark-to-market|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.<ref name="isda.org"/>
 
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.<ref>{{cite web|url=http://www.spectator.co.uk/business/trading-floor/2556276/daily-brief.thtml| title=Daily Brief |date = October 28, 2008 | accessdate = November 6, 2008 }}</ref>
 
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)."<ref>{{cite web|url=http://www.berkshirehathaway.com/2002ar/2002ar.pdf |format=PDF| title = Berkshire Hathaway Inc. Annual Report 2002 | date=February 21, 2003 | accessdate=September 21, 2008 | publisher = [[Berkshire Hathaway]] | first = Warren |last=Buffett}}</ref>
 
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&nbsp;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 to $360&nbsp;billion.<ref>Olsen, Kim Asger, [http://www.atimes.com/atimes/Global_Economy/JJ22Dj03.html  "Pay-up time for Lehman swaps"], ''atimes.com'', October 22, 2008.</ref>
 
Despite Buffett's criticism on derivatives, in October 2008 Berkshire Hathaway revealed to regulators that it has entered into at least $4.85&nbsp;billion in derivative transactions.<ref>{{cite news|last=Holm |first=Erik |url=http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aQwp2qwvFuE8 |title=Berkshire Asked by SEC in June for Derivative Data (Update1) |publisher=Bloomberg |date=November 21, 2008 |accessdate=August 27, 2010}}</ref>  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 inititated, so that Berkshire always holds the money.<ref>{{cite web|url=http://www.berkshirehathaway.com/letters/2008ltr.pdf |format=PDF | title = Berkshire Hathaway Inc. Annual Report 2008 | accessdate=December 21, 2009 | publisher = Berkshire Hathaway | first = Warren |last=Buffett}}</ref>  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.<ref>[http://www.bloomberg.com/apps/news?pid=20601109&sid=aw1Oh4B0Wvv8 Ambac, MBIA Lust for CDO Returns Undercut AAA Success (Update2)] , Christine Richard, bloomberg, jan 22, 2008. Retrieved 2010 4 29.</ref><ref>[http://www.euromoney.com/Article/1990954/Credit-default-swaps-Monolines-face-litigious-and-costly-endgame.html Credit Default Swaps: Monolines faces litigious and costly endgame], Aug 2008, Louise Bowman, euromoney.com. Retrieved 2010 4 29.</ref> In 2009 one of the monolines, [[MBIA]], sued [[Merrill Lynch]], claiming that Merill had misrepresented some of its CDOs to MBIA in order to persuade MBIA to write CDS protection for those CDOs.<ref>{{cite web | url = http://www.mbia.com/investor/publications/Complaint2912075.pdf | format=PDF | date = April 2009 | accessdate = 2010-04-23 | author = Supreme Court of New York County | publisher = mbia.com | title = MBIA Insurance Co. v Merrill Lynch }}
 
</ref><ref>[http://online.wsj.com/article/SB124112607580674555.html MBIA Sues Merrill Lynch ], Wall Street Journal, Serena Ng, 2009 May 1. Retrieved 2010 4 23.</ref><ref>[http://www.reuters.com/article/idUSN0923921520100409 UPDATE 1-Judge dismisses most of MBIA's suit vs Merrill] Apr 9, 2010, Reuters, Edith Honan, ed. Gerald E. McCormick
 
</ref>
 
===Systemic risk===
During the [[Global financial crisis of 2008|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.<ref>{{cite web|author=Investing Daily |url=http://kciinvesting.com/articles/9432/1/AIG-the-Global-Financial-System-and-Investor-Anxiety/Page1.html |title=AIG, the Global Financial System and Investor Anxiety |publisher=Kciinvesting.com |date=September 16, 2008 |accessdate=August 27, 2010}}</ref>  So far this does not appear to have happened, although some commentators{{Who|date=November 2009}} have noted that because the total CDS exposure of a bank is not public knowledge, the fear that one could face large losses or possibly even default themselves was a contributing factor to the massive decrease in lending liquidity during September/October 2008.<ref>{{cite web|author=Sam Fleming, Daily Mail16 October 2008, 12:00am Data |url=http://www.thisismoney.co.uk/investing-and-markets/article.html?in_article_id=455675&in_page_id=3 |title=Banks caught in jaws of CDS menace |publisher=This is Money |date=October 16, 2008 |accessdate=August 27, 2010}}</ref>
 
Chains of CDS transactions can arise from a practice known as "netting".<ref>[http://www.npr.org/templates/story/story.php?storyId=96395271&ft=1&f=94427042 Unregulated Credit Default Swaps Led to Weakness].  All things Considered, National Public Radio.  Oct 31, 2008.</ref>  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 [[#Market|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.
 
{{see also|Category:Systemic risk}}
 
==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).<ref name=JournalTaxation1>{{cite journal |author1=Nirenberg, David Z. |author2=Steven L. Kopp. |title=Credit Derivatives: Tax Treatment of Total Return Swaps, Default Swaps, and Credit-Linked Notes |journal=Journal of Taxation date=August 1997 }}</ref><ref name=Peaslee>{{cite journal |title=Federal Income Taxation of Securitization Transactions: Cumulative |volume=Supplement No. 7 |date= November 26, 2007 |url=http://www.securitizationtax.com |page=83 |accessdate=July 28, 2008 |author1=Peaslee, James M. |author2=David Z. Nirenberg }}</ref><ref name=Brandes>{{cite web |author=Ari J. Brandes |title=A Better Way to Understand Credit Default Swaps |journal=Tax Notes |date=July 21, 2008 |url=http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1121263 }}</ref> <ref group=notes>The link is to an earlier version of this paper.</ref> Commentators have suggested that, depending on how they are drafted, they are either [[notional principal contract]]s or [[Option (finance)|options]] for tax purposes,(Peaslee & Nirenberg 2008-07-21:129).<ref name=Peaslee /> 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).<ref name=JournalTaxation1 /> 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.<ref name=autogenerated2>''Id.''</ref> 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.<ref name=autogenerated2 />  In 2004, the [[Internal Revenue Service]] announced that it was studying the characterization of CDS in response to taxpayer confusion.<ref>Peaslee & Nirenberg, 89.</ref> 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.<ref>I.R.S. REG-111283-11, IRB 2011-42 (Oct. 17, 2011).</ref>  These proposed regulations&mdash;which are yet to be finalized&mdash;have already been subject to criticism at a public hearing held by the IRS in January 2012,<ref>Diane Freda, I.R.S. Proposed Rules Mistakenly Classify Section 1256 Contracts, I.R.S. Witnesses Say, DAILY TAX REP. (BNA) No. 12 at G-4 (Jan. 20, 2012).</ref>  as well as in the academic press,<ref name="James Blakey 2013">James Blakey, Tax Naked Credit Default Swaps for What They Are:  Legalized Gambling, 8 U. Mass. L. Rev. 136 (2013).</ref>  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,<ref name="James Blakey 2013"/>  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,<ref>See Hearing to Review the Role of Credit Derivatives in the U.S. Economy, Before H. Comm. on Agriculture, at 4 (Nov. 20, 2008) (statement of Eric Dinallo, Superintendent of New York State Ins. Dept.) (declaring that “[w]ith the proliferation of various kinds of derivatives in the late 20th Century came legal uncertainty as to whether certain derivatives, including credit default swaps, violated state bucket shop and gambling laws. [The Commodity Futures Modernization Act of 2000] created a ‘safe harbor’ by . . . preempting state and local gaming and bucket shop laws . . .”) available at http://www.dfs.ny.gov/about/speeches_ins/sp0811201.pdf.</ref>  it exempted them from “any State or local law that prohibits or regulates gaming.”<ref>Commodity Futures Modernization Act of 2000, H.R. 5660, 106th Cong. § 117(e)(2).</ref>  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<ref>{{cite web|url=http://www.fasb.org/st/summary/stsum133.shtml |title=FASB 133 |publisher=Fasb.org |date=June 15, 1999 |accessdate=August 27, 2010}}</ref> 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]].<ref>[http://web.archive.org/web/20091026170512/http://www.creditfixings.com/information/affiliations/fixings/auctions/2007/movie_gallery.html "Final Results of the Movie Gallery Auction, October 23, 2007"]. (archived 2009)</ref>
 
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.
 
==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)|''Inside Job'' (2010 film)]], an Oscar-winning documentary film about the financial crisis of 2007–2010 by Charles H. Ferguson
*[[Recovery swap]]
*[[Toxic security]]
*[[IntercontinentalExchange]]
 
==Notes==
{{Reflist|group=notes}}
 
==References==
{{Reflist|30em}}
 
==External links==
{{Wiktionary}}
* [http://www.datagrapple.com/ Interactive data visualizations of 680 Credit Default Swaps (Sovereign, Corporate, Financial) and indices]
* [http://www.euractiv.com/en/euro/barroso-considers-ban-speculation-sovereign-debt-news-325532 Barroso considers ban on speculation with banning purely speculative naked sales on credit default swaps of sovereign debt]
* [http://derivativedribble.wordpress.com/2008/10/23/systemic-counterparty-confusion-credit-default-swaps-demystified/ "Systemic Counterparty Confusion: Credit Default Swaps Demystified"]. [[Derivative Dribble]]. October 23, 2008.
* [http://www.cbsnews.com/video/watch/?id=4546583n&tag=mncol;lst;3 CBS '60 minutes' video on CDS]
* [http://www.isda.org/publications/copyrightspolicy.html 2003 ISDA Credit Derivatives Template]. [[International Swaps and Derivatives Association]]
* [http://chicagofed.org/webpages/publications/understanding_derivatives/index.cfm: Understanding Derivatives: Markets and Infrastucture] Federal Reserve Bank of Chicago, Financial Markets Group
* [http://www.bis.org/publ/regpubl.htm BIS - Regular Publications]. [[Bank for International Settlements]].
* [http://www.probability.net/credit.pdf A Beginner's Guide to Credit Derivatives] - Nomura International Probability.net
* [http://www.ft.com/cms/s/e463523a-62b4-11db-8faa-0000779e2340.html "A billion-dollar game for bond managers"]. ''[[Financial Times]]''.
* {{cite paper | first = Darrell | last = Duffie | authorlink = Darrell Duffie | title = Credit Swap Valuation | id = {{citeseerx|10.1.1.139.4044}} | publisher = [[Stanford Graduate School of Business]] }}
* [[John C. Hull]] and [[Alan White (economist)|Alan White]]. [http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf "Valuing Credit Default Swaps I: No Counterparty Default Risk"]. [[University of Toronto]].
* [http://www.smartquant.com/references/SWAP/swap2.pdf Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations]. Smartquant.com
* [http://pages.stern.nyu.edu/~mgruber/working%20papers/explaining_rate_final_JF.pdf Elton et al., Explaining the rate spread on corporate bonds]
* [http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf Warren Buffett on Derivatives - Excerpts from the Berkshire Hathaway annual report for 2002.] fintools.com
* [http://www.financialsensearchive.com/editorials/cooke/2008/1006.html The Real Reason for the Global Financial Crisis]. [[Financial Sense Archive]]
* [http://www.privateequitycouncil.org/wordpress/wp-content/uploads/adl-pe-primer-fin-r2.pdf Demystifying the Credit Crunch]. [[Private Equity Council]].
* [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1346552 "The AIG Bailout"] William Sjostrom, Jr.
* [http://www.cdsmodel.com/ Standard CDS Pricing Model Source Code] - ISDA and [[Markit]]. CDSModel.com
* List of CDS premiums of various countries in [http://translate.google.com/translate?js=n&prev=_t&hl=de&ie=UTF-8&u=http%3A%2F%2Fverlorenegeneration.de%2Flanderisiken-im-uberblick%2F&sl=de&tl=en&history_state0= English translation from German]
*[http://www.quantcalc.net/CDS.html Calculators for Credit Default Swap]. QuantCalc, Online Financial Math Calculator
*[http://www.quantcalc.net/CDS_FromHazard.html Calculators for Credit Default Swap with hazard rate]. QuantCalc, Online Financial Math Calculator
 
===News===
* Zweig, Phillip L. (July 1997), ''BusinessWeek'' [http://www.businessweek.com/archives/1997/b3536094.arc.htm New ways to dice up debt - Suddenly, credit derivatives-deals that spread credit risk--are surging]
* Goodman, Peter (Oct 2008) New York Times [http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?_r=1&ref=business&oref=slogin The spectacular boom and calamitous bust in derivatives trading]
* Pulliam, Susan and Ng, Serena (January 18, 2008), ''Wall Street Journal'': "[http://online.wsj.com/article/SB120061980722699349.html Default Fears Unnerve Markets]"
* Das, Satayjit (February 5, 2008), ''Financial Times'': "[http://www.ft.com/cms/s/0/f75c80e4-d3fd-11dc-a8c6-0000779fd2ac.html CDS market may create added risks]"
* Morgenson, Gretchen (February 17, 2008), ''New York Times'': "[http://www.nytimes.com/2008/02/17/business/17swap.html?pagewanted=1&_r=1&ref=todayspaper Arcane Market is Next to Face Big Credit Test]"
* March 17, 2008 [http://www.time.com/time/business/article/0,8599,1723152,00.html Credit Default Swaps: The Next Crisis?], ''Time''
* Schwartz, Nelson D. and Creswell, Julie (March 23, 2008), ''New York Times'': "[http://www.nytimes.com/2008/03/23/business/23how.html Who Created This Monster?]"
* Evans, David (May 20, 2008), Bloomberg: "[http://www.bloomberg.com/apps/news?pid=20601109&sid=aCFGw7GYxY14 Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults]"
* van Duyn, Aline (May 28, 2008), ''Financial Times'': "[http://us.ft.com/ftgateway/superpage.ft?news_id=fto052820081032091987 Moody's issues warning on CDS risks]"
* Morgenson, Gretchen (June 1, 2008), ''New York Times'': "[http://www.nytimes.com/2008/06/01/business/01gret.html First Comes the Swap. Then It’s the Knives.]"
* Kelleher, James B. (September 18, 2008), Reuters: "[http://www.reuters.com/article/newsOne/idUSN1837154020080918?sp=true Buffett's 'time bomb' goes off on Wall Street.]"
* Morgenson, Gretchen (September 27, 2008), ''New York Times'': "[http://www.nytimes.com/2008/09/28/business/28melt.html?em Behind Insurer’s Crisis, Blind Eye to a Web of Risk]"
* Varchaver, Nicholas and Benner, Katie (Sep 2008), ''Fortune Magazine'': "[http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/index.htm?postversion=2008093012 The $55&nbsp;Trillion Question]" - on CDS spotlight during financial crisis.
*{{Cite news | first= John | last= Dizard | title= A billion dollar game | date= October 23, 2006 | publisher= | url = http://us.ft.com/ftgateway/superpage.ft?news_id=fto102320061114181979 | work = Financial Times | pages = | accessdate = October 19, 2008 }}
* October 19, 2008, Portfolio.com: "[http://www.portfolio.com/views/blogs/market-movers/2008/10/19/why-the-cds-market-didnt-fail Why the CDS Market Didn't Fail]" Analyzes the CDS market's performance in the Lehman Bros. bankruptcy.
* Boumlouka, Makrem (April 8, 2009), Wall Street Letter: "[http://www.wallstreetletter.com/Article.aspx?ArticleID=2177796 Credit Default Swap Market: “Big Bang”? ]".
{{Derivatives market}}
 
{{DEFAULTSORT:Credit Default Swap}}
[[Category:Derivatives (finance)]]
[[Category:Systemic risk]]
[[Category:United States housing bubble]]

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