Credit default swap, CDS (also referred to in German as Kreditausfall-Swap or Kreditausfall-Versicherung)

A financial product introduced in 1994 to market default risks of bonds or loans (a bilateral over-the-counter contract in which the seller agrees to make a payment to the buyer in the event of a specified credit event in exchange for a fixed payment or a series of fixed payments).- The basis – the underlying asset – is tradable debt. The CDS is thus a product derived from the underlying asset: a derivative and practically an insurance premium for the default risk, a credit risk transfer. More precisely, only the risk is traded, but not also – as can be read even in textbooks! – the credit as a whole. – By concluding a CDS, the fixed rate payer undertakes to make a compensation payment to the floating rate payer in the event of a precisely defined credit event, usually defined by reference to the master agreements of the International Swaps and Derivates Association (ISDA). In return, the floating rate payer receives a premium from the protection buyer. The amount of the premium depends mainly on: – the creditworthiness of the transferor, i.e. the reference debtor; – the term of the contract; – the precise definition of the credit event, such as default, partial default, full default, etc. The amount of the premium is determined by the ISDA: default, partial default, total default, and – the creditworthiness of the protection seller (risk taker). – The premium for CDSs has now become a widely respected indicator of the credit quality of companies, banks and, in the case of sovereign bonds, entire countries. CDSs have so far been traded over-the-counter; this allows for very specific, non-standardized requests from both counterparties. The CDS market often anticipates rating downgrades. – The volume of CDS rose steeply from USD 1,000 billion in 2002 to USD 17,000 billion at the end of 2005, and has risen to USD 62,000 billion by the fall of 2008: that is roughly the size of the gross national product of the entire world. Participants in this credit risk transfer market include not only banks but also hedge funds and pension funds. – Since the subprime crisis, central banks and regulators have stepped up their efforts to make the CDS market more transparent. Reporting requirements were low and trading unregulated. Counterparties, particularly weakly regulated insurance companies in the USA, ran into difficulties in the course of the financial crisis that followed the subprime crisis. As a result, banks suffered substantial losses of loan items in the trading book; and this at a time when institutions were burdened by the withdrawal of largely illiquid assets from special purpose vehicles. Only Eurex Credit Clear, established at the insistence of the EU Commission, brought some more firmness to this market. – See collateralized debt obligation, synthetic, credit default swap indices, Euronet, hub, credit derivative, pooling of collateral, portfolio insurance, rating, speculation, destructive, trade assignment. – Cf. BaFin’s Annual Report 2003, p. 22; Deutsche Bundesbank’s Monthly Report of December 2004, p. 43 ff. (there also a description of many details of the market and overviews); Deutsche Bundesbank’s Monthly Report of October 2005, p. 87 (CDSs as an expression of market opinion about a bank’s creditworthiness; p. 88: 2003-2005 premiums of German banks in comparison), Deutsche Bundesbank Monthly Report of March 2006, p. 37 ff. (information also on the regulatory environment), Cf. BaFin Annual Report 2007, p. 31 f. (abrupt turnaround in CDSs in the wake of the subprime crisis; overview), BaFin Annual Report 2008, p. 46 (post-trade transparency requirements), BaFin Annual Report 2009, p. 164 ff. (complaints regarding Lehman certificates), Deutsche Bundesbank Annual Report 2010, p. 91 (premiums 2007 to 2011), BaFin Annual Report 2010, p. 29 (CDS for large German banks 2009 and 2010 Monthly Report of the Deutsche Bundesbank of November 2011, p. 45 (credit default swap premiums since 2007), BaFin Annual Report 2012, p. 34 (premiums since 2009), and the respective BaFin Annual Report, chapter “Economic Environment.”

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University Professor Dr. Gerhard Merk, Dipl.rer.pol., Dipl.rer.oec.
Professor Dr. Eckehard Krah, Dipl.rer.pol.
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