Credit Default Swaps - Overview

    2025, May 30
  • CDS risk
  • Bringing CDS to the Blockchain: Is It Feasible?
  • Difference between US and UE
  • Reference

    • A Credit Default Swap (CDS) is a financial derivative that functions as a form of insurance against the default of a borrower. It allows one party to transfer the credit risk of a fixed income product to another party in exchange for a premium.

    Since their inception in the early 1990s, CDS contracts have played a pivotal role in credit markets, offering both hedging tools and speculative opportunities.

    [TOC]

    How a Credit Default Swap Works

    In a CDS agreement, there are typically two parties:

    • Protection buyer: Pays periodic fees (premiums) to the seller.

    The buyer of a CDS obtain the right to sell the bonds issue by the reference entity for their face value, when there is a credit event, that is a default.

    • Protection seller: Promises to compensate the buyer if a credit event (e.g., default, bankruptcy, or restructuring of the reference entity) occurs.

    The seller of a CDS is obliged to buy the bonds for their face value when the credit event occurs

    • The total face value of all the bonds, which are part of the CDS is known as the notional principal

    For example, if Company X issues bonds and an investor fears that X may default, they can buy a CDS from a bank. If X defaults, the bank pays the investor the face value of the bond. If no default occurs, the bank keeps the premiums.

    Key terms

    • The company subject to default is known as reference entity
    • THe default is called credit event

    Reference: TW3421x - Week 7 - Credit Default Swaps

    CDS spread

    The CDS spread is nothing more than the total amount paid every year by the buyer as a percent of the nominal principal.

    • The CDS spread is the “price” (the extra rate) required by the seller of the CDS to bear the risk of default of the reference entity.
    • CDS spread (but in general all credit spreads) can be used to quicly estimate the probability of default (PD) of a counterparty
      • In general, we can compute the average PD of the reference entity, conditional on no previous default, as

    [\begin{aligned} PD = \frac {CS} {1 - R} \end{aligned}]

    Where:

    PD is the probability of default

    CS is the CDS spread

    R is the recovery rate

    • This estimation is not extremely precise, and it is subject to rather strong assumptions from a probabilistic point of view, but it is surely quick and may be helpful to have a first idea about the creditworthiness of a counterparty.

    Reference: TW3421x - Week 7 - Credit Default Swaps

    Example

    Example 1

    Suppose that a 5-year CDS spread (CS) for a given company (the reference entity) is 240 bps per year, i.e 2.4% per year.

    • Assume that the recovery rate(R) in case of default is 40%.
    • The average (yearly) PD over the 5-year period, conditional on no earlier default is estimated as:

    [\begin{aligned} \frac{0.024}{1-0.4} = 0.04 = 4% \end{aligned}]

    Example 2

    Suppose that, for the same reference entity, the 3-year CDS spread is 50 bps while the 5-year CDS spread is 60 bps with a recovery rate of 60%.

    • The average PD over 3 year is 0.005 / (1-0.6) = 0.0125
    • The average PD over 5 years is 0.006 / (1-06) = 0.015

    The average PD between year 3 and year 5 is: \(\begin{aligned} \frac {5 * 0.0125 - 3 * 0.015}2 = 0.01875 = 1.875% \end{aligned}\)

    • The general formula for inferring the intermediate average PD between an y-ear CDS and x-year CDS, with y > x, is

    [\begin{aligned} \frac{y * PD_y - x * PD_x}{y-x} \end{aligned}]

    Where PDx is the average PD for the x-year CDS.

    Example

    On June 20, 2014, tow parties agree to enter into a 5-year CDS with respect to a specific reference entitiy

    • The notional principal is $100 million.

    • The buyer agrees to pay 90 basis points per year, in quartlerly arrears for protection against default by the reference entity
    • The CDS spread is 90 bps, that is 0.9%.

    No default

    In case of no default, that is no credit event, the buyer receives no payout, while s/he pays the seller about $225k on September 20, December 20, March 20 and June 20 in 2014, 2015, 2016, 2017, 2018, 2019.

    90 bps of 100’000’00 is 900’000. Then 900’000 / 4 = 225’000

    Default

    Now image that there is a credit event, i.e a default.

    This default happens in moth 5 of year 3, that is around November 20 2017.

    In that case, the buyer stops paying the seller and claims the notional principal.

    The seller is obliged to pay the notional principal (or any other arrangement) to the buyer, by buying all the bonds involved in the CDS.

    Since the buyer’s payments are in arrears, and the default event happens in November, a final accrual payment is requires.

    In particular, the buyer must pay his/her insurance for October and November 2017, until the credit event. That is:

    900’000 / 12 * 2 = 150’000

    CDS as a derivative: Naked CDS vs. Covered CDS

    A net short position can also be achieved by the use of derivatives, including Credit Default Swaps (CDS).

    For example, if an investor buys a CDS without being exposed to the credit risk of the underlying bond issuer (a so-called “naked CDS”), he is expecting, and potentially gaining from, rising credit risk. This is equivalent to short selling the underlying bond.

    Reference: Regulation on Short Selling and Credit Default Swaps - Frequently asked questions

    Covered CDS

    A covered CDS is when you own the underlying bond and buy a CDS to protect against its default. It’s like insuring something you actually own.

    Naked CDS

    A naked CDS is when you buy the CDS without owning the bond. You’re not protecting against a loss — you’re speculating.

    • This means the investor doesn’t actually hold the bond but buys the CDS betting that the issuer’s creditworthiness will worsen (i.e., default risk increases).
    • If the market thinks the issuer is more likely to default, the value of the CDS increases, and the buyer can potentially sell it at a profit.
    Why it’s like short selling
    • In short selling a bond, you’re betting its price will fall — which happens when the issuer is at greater risk of default.
    • Similarly, a naked CDS buyer profits when the issuer looks more likely to default.
    • Both strategies benefit from worsening credit conditions for the bond issuer.

    Reference: ChatGPT + CFI - Naked Credit Default Swaps

    CDS risk

    CDS markets can enhance liquidity and allow institutions to manage risk efficiently. However, they also pose significant systemic risks, which became especially evident during the 2008 financial crisis. Some major risks include:

    Counterparty Risk

    The protection seller may itself default, rendering the CDS protection worthless. This is what happened with AIG in 2008, which had sold massive amounts of CDS without sufficient capital backing.

    Lack of Transparency

    Traditionally, CDS contracts have been traded over-the-counter (OTC), meaning they are privately negotiated and not standardized. This obscures the true extent of exposures and interconnections in the financial system.

    Speculation and Leverage

    CDSs can be used not only for hedging but also for speculation. Investors can buy CDS contracts on debt they don’t actually own—akin to buying insurance on a neighbor’s house. This speculative use can amplify losses in a downturn.

    Case Study: The AIG Collapse and CDS Fallout

    The story of AIG (American International Group) is one of the most infamous examples of CDS risk gone wrong.

    In the early 2000s, AIG’s Financial Products division aggressively entered the CDS market, selling protection on billions of dollars’ worth of mortgage-backed securities (MBS), particularly collateralized debt obligations (CDOs). Many of these securities were rated AAA, so AIG saw them as low-risk and didn’t require collateral or set aside sufficient capital reserves.

    However, when the U.S. housing market began to collapse in 2007–2008, the value of these mortgage securities plummeted, and rating agencies began downgrading them. As a result, AIG was required to post massive amounts of collateral to counterparties under the terms of its CDS agreements. The company quickly found itself unable to meet these obligations.

    At its peak, AIG had over $400 billion in CDS exposure. As panic spread, counterparties lost confidence, demanding more collateral and cash that AIG simply didn’t have. The company faced imminent collapse.

    To prevent a domino effect across the global financial system—since many major banks held CDS contracts with AIG—the U.S. government stepped in with a historic bailout, providing over $180 billion in loans and capital injections. In effect, AIG was “too interconnected to fail.”

    This episode highlighted the unregulated, opaque nature of the CDS market and the devastating systemic risk that arises when such contracts are concentrated in a few major institutions without proper oversight.

    Reference: U.S Department of the Treasury - AIG, Wikipedia - AIG

    Bringing CDS to the Blockchain: Is It Feasible?

    The application of blockchain technology to credit default swaps is increasingly being explored as a way to address transparency and efficiency issues.

    Benefits of CDS on Blockchain

    • Transparency: A blockchain ledger can make CDS positions and exposures visible in real-time through the use of public blockchain.
    • Smart Contracts: CDS terms could be codified into smart contracts, ensuring automatic execution of payouts when predefined transactions are triggered.
    • Reduced Counterparty Risk: Using decentralized finance (DeFi) principles and collateralized protocols, blockchain-based CDS could reduce the risk of one party defaulting.
    • Auditability and Traceability: Each transaction is permanently recorded, making audits simpler and reducing potential fraud.

    Challenges and Risks

    • Oracle Risk: Smart contracts require reliable external data (“oracles”) to verify credit events like defaults. Manipulated or inaccurate oracles could cause incorrect payouts.
    • Regulatory Uncertainty: Financial derivatives on blockchains raise complex regulatory questions, especially when spanning multiple jurisdictions.
    • Liquidity Concerns: A decentralized CDS market might struggle to match the liquidity of traditional financial institutions, at least initially.
    • Complexity of Events: Credit events are often nuanced and legally complex, sometimes requiring subjective judgment or court rulings—difficult to automate via code.

    Difference between US and UE

    There are key differences between how Credit Default Swaps (CDS) operate in the United States (US) and the European Union (EU), though the instruments are fundamentally similar. The distinctions mainly arise from regulation, market structure, and legal definitions of credit events.

    Regulatory Framework

    United States (US)*

    • Regulated primarily by the Commodity Futures Trading Commission (CFTC) under the Dodd-Frank Act (passed after the 2008 crisis).
    • Dodd-Frank mandates:
      • Central clearing of standardized CDS through clearinghouses.
      • Trade reporting to swap data repositories (SDRs).
      • Margin requirements and position limits.
      • Registration of major swap participants.

    European Union (EU)

    CDS are regulated under several frameworks:

    • EMIR (European Market Infrastructure Regulation) – requires central clearing, reporting, and risk mitigation for OTC derivatives.
    • MiFID II/MiFIR – imposes transparency and market conduct rules. See ESMA finalises MiFID II’s derivatives trading obligation (2017)
    • MAR (Market Abuse Regulation) – applies to insider trading or market manipulation involving CDS.
    • Short Selling Regulation (SSR) – uniquely, the EU restricts “naked” sovereign CDS trading (see below). See esma.europa.eu - Short Selling

    Sovereign CDS: The EU’s Special Rules

    One of the most important differences lies in how the EU treats sovereign CDS (i.e., CDS on government debt).

    • In the EU, under the Short Selling Regulation, it is prohibited to buy sovereign CDS without holding an insurable interest (i.e., no “naked” positions).
      • This rule was introduced after the Eurozone debt crisis, as policymakers believed speculation via CDS was exacerbating the stress on countries like Greece, Portugal, and Spain.
      • Reference: ESMEA - Short Selling
    • In contrast, the US does not prohibit naked CDS positions, whether on corporate or sovereign debt.

    Credit Event Determination

    Both regions use the ISDA (International Swaps and Derivatives Association) framework to define credit events like default, restructuring, and failure to pay. However:

    • EU contracts are more likely to be governed by English law, while US CDS contracts typically fall under New York law. This can affect interpretations, especially for complex restructuring events.
    • There have been notable cases (e.g., Greece’s debt restructuring in 2012) where the definition of a credit event was controversial, and market participants in the EU faced uncertainty due to different legal and regulatory environments.

    Market Structure and Participants

    • The US CDS market is larger and more liquid overall, particularly in corporate CDS.
    • In the EU, the CDS market is smaller and subject to stricter controls, particularly on sovereign debt. European banks and institutions also tend to be more cautious with CDS exposure due to regulatory pressure and public perception.
    • European Central Counterparties (CCPs) such as LCH and Eurex play a key role in clearing, just as ICE Clear Credit does in the US.

    Summary of Key Differences

    Aspect United States European Union
    Regulatory Body CFTC (Dodd-Frank / CFTC Issues Clearing Determination for Certain Credit Default Swaps and Interest Rate Swaps) ESMA, local regulators (EMIR, MiFID II, SSR)
    Central Clearing Mandatory for standardized CDS Mandatory for standardized CDS
    Naked Sovereign CDS Allowed Prohibited
    Governing Law Usually New York law Often English law
    Market Size Larger, more liquid Smaller, more regulated
    Credit Event Handling ISDA (NY law) ISDA (often UK law)
    Reporting Requirements Swap Data Repositories Trade Repositories (under EMIR)

    Summary

    While CDS contracts in the US and EU share the same core mechanics, their regulatory environments differ significantly, especially when it comes to sovereign CDS and speculative activity.

    • The EU’s stricter controls reflect a more conservative and politically sensitive approach
    • The US allows greater flexibility, especially for hedge funds and speculative investors.

    These differences impact how investors hedge, speculate, and manage risk across jurisdictions.

    Mindmap

    Made with the help of ChatGPT

    credit-default-swap-mindmap

    Reference

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