Credit Default Swap

A credit default swap, or CDS, is a financial swap agreement in which the seller of the CDS agrees to compensate the buyer if a debtor defaults or experiences another specified credit event. In practical terms, the seller is providing protection against the default of a reference asset. The buyer pays a regular fee, often called the CDS spread, and in return expects a payment if the underlying asset defaults.

If a default occurs, the buyer of the CDS generally receives compensation, usually based on the face value of the loan or bond, while the seller may take possession of the defaulted loan or pay its market value in cash. CDS contracts can also be purchased by people who do not own the underlying loan or bond and who do not have a direct insurable interest in it; these are known as naked CDSs. In cases where there are more CDS contracts outstanding than the actual bonds in existence, a credit event auction is used to determine settlement, and the resulting payment is often much lower than the face value of the loan.

Overview

Credit default swaps in their modern form have existed since the early 1990s and became much more widely used in the early 2000s. By the end of 2007, the outstanding notional amount of CDS contracts was estimated at $62.2 trillion. This figure later fell to $26.3 trillion by mid-2010 and was reportedly $25.5 trillion in early 2012. As of 2009, CDSs were not traded on an exchange and transaction reporting to a government agency was not required.

During the 2008 financial crisis, regulators became concerned about the lack of transparency in the CDS market because of its potential to create systemic risk. In March 2010, the Depository Trust & Clearing Corporation announced that it would provide regulators greater access to its CDS database. By June 2018, there was reportedly $8 trillion in notional value outstanding.

Description

A buyer purchases a CDS at time t0 and makes regular premium payments at later dates such as t1, t2, t3, and t4. If the underlying credit instrument does not suffer a credit event, the buyer continues paying premiums until the contract ends at tn. If a credit event occurs at, for example, t5, then the seller pays the buyer for the loss and the buyer stops making further premium payments.

A CDS is a credit derivative contract between two counterparties. The buyer pays periodic premiums to the seller and receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. The CDS may refer to a specified loan or bond obligation of a reference entity, which is usually a corporation or a government. The reference entity itself is not a party to the contract. The premium payments represent the spread charged by the seller and are usually quoted in basis points as compensation for taking on credit risk.

A default is usually described as a credit event and may include failure to pay, restructuring, bankruptcy, or even a downgrade in credit rating. CDS contracts on sovereign debt often include repudiation, moratorium, and acceleration as credit events. Most CDS contracts are in the $10 million to $20 million range and have maturities between one and ten years, with five years being the most common maturity.

An investor may buy protection to hedge the risk of default on a bond or other debt instrument even if the investor does not hold the instrument. In this way, a CDS resembles credit insurance, though it is not regulated in the same way as traditional insurance. Investors may also buy and sell protection without owning the debt, creating naked CDS positions. These contracts can be used to create synthetic long and short positions in a reference entity, and they are also used in capital structure arbitrage.

As an example, if an investor buys a CDS from AAA-Bank and the reference entity is Risky Corp, the investor pays regular premiums to AAA-Bank. If Risky Corp defaults, the investor receives a one-time payment from AAA-Bank and the contract ends.

If the investor owns Risky Corp debt, the CDS serves as a hedge. If the investor does not own the debt, the CDS can be used for speculation or to hedge other investments whose fortunes may be linked to Risky Corp. If Risky Corp defaults, settlement may occur in two ways. Under physical settlement, the investor delivers the defaulted asset to the bank and receives the par value. Under cash settlement, the bank pays the difference between par value and the market price of the debt obligation.

The spread of a CDS is the annual amount the protection buyer must pay the seller, expressed as a percentage of the notional amount. For example, if the CDS spread is 50 basis points, then a buyer of $10 million in protection pays $50,000 per year. These payments are normally made quarterly and continue until the contract expires or the reference entity defaults.

All else being equal, a CDS with a higher spread is usually seen by the market as indicating a greater probability of default, although liquidity and expected recovery values can also affect the comparison. Credit spread rates and credit ratings are often considered important indicators of the likelihood that the seller of protection will have to make a payout.

Differences from Insurance

CDS contracts resemble insurance because the buyer pays a premium and receives money if an adverse event occurs. However, there are important differences. Insurance usually indemnifies actual losses suffered on an asset in which the policyholder has an insurable interest, while a CDS pays an agreed amount to all holders according to market convention, regardless of whether they actually own the underlying security or suffered a loss.

Other differences include the possibility that the seller is not a regulated entity, the fact that the seller is not required to maintain reserves in the same way as an insurer, and the absence of an obligation for the buyer to disclose all known risks in the same manner as insurance. CDS dealers manage risk mainly through hedging in other CDS contracts and the bond market, while insurers rely on reserves and actuarial methods. CDS contracts are generally marked to market, which can create volatility in accounting statements. Hedge accounting under U.S. GAAP may not be available unless specific requirements are met. To cancel an insurance contract, a buyer can often simply stop paying premiums, but a CDS usually needs to be unwound.

Risk

When entering into a CDS, both the buyer and seller face counterparty risk. The buyer risks that the seller may default and fail to pay when needed. If both the seller and the reference entity default at the same time, the buyer loses protection. If the seller defaults while the reference entity survives, the buyer may need to replace the CDS at a higher cost.

The seller faces the risk that the buyer may default on its payments, reducing expected income. Sellers often hedge their exposure by entering into offsetting CDS positions or related bond market transactions. If the buyer drops out, the seller may need to unwind the hedge or sell a new CDS at a less favorable price, which can cause losses.

If CDSs are traded and settled through a central clearing house, counterparty risk can be reduced because the clearing house becomes the central counterparty. Like other over-the-counter derivatives, CDS contracts can also involve liquidity risk and margin calls. The required collateral can change over time if market prices shift or if a party’s credit quality changes. Some CDS contracts also require an upfront fee consisting of a reset-to-par amount and an initial coupon.

A further risk for the seller is jump risk, also called jump-to-default risk. A seller may collect premiums for a long time with little expectation of default, but when default occurs the seller suddenly owes a very large amount. This type of risk is particularly severe in CDS contracts.

Sources of Market Data

Market data on CDSs comes from several main sources. Annual and semiannual data has been published by the International Swaps and Derivatives Association since 2001 and by the Bank for International Settlements since 2004. The Depository Trust & Clearing Corporation provides weekly data through its Trade Information Warehouse, although publicly available data goes back only one year. The figures from these sources do not always match because they use different sampling methods. Daily, intraday, and real-time data has also been available from S&P Capital IQ through its acquisition of Credit Market Analysis in 2012.

According to DTCC, the Trade Information Warehouse is the only global electronic database for virtually all CDS contracts outstanding in the marketplace. The Office of the Comptroller of the Currency also publishes quarterly data on credit derivatives for insured U.S. commercial banks and trust companies.

Uses

Credit default swaps are used for speculation, hedging, and arbitrage.

Speculation

CDS contracts allow investors to speculate on changes in CDS spreads for single entities or market indices such as CDX and iTraxx. A market participant may believe that a company’s CDS spread is too high or too low relative to its bond yields and attempt to profit through basis trades involving a CDS, a cash bond, and an interest rate swap.

Investors may also speculate directly on whether a company’s credit quality will improve or worsen. Since CDS spreads usually rise when creditworthiness declines, buying protection is effectively a way to bet that the company may default. Selling protection is a way to express the opposite view. The seller is considered long on the CDS and the underlying credit, while the protection buyer is considered short.

CDSs opened new avenues for speculation because investors could go long on a bond without buying the bond itself. They only had to promise to pay if default occurred. At the same time, shorting bonds was often difficult in practice, so CDSs made it easier to take a short credit position. Such positions are often called synthetic long or synthetic short positions because the speculator does not actually own the underlying bond.

For example, a hedge fund that believes Risky Corp will default might buy $10 million of CDS protection for two years at 500 basis points per year. If Risky Corp defaults after one year, the hedge fund pays $500,000 in premiums but receives $10 million, assuming zero recovery and sufficient liquidity from the seller. If Risky Corp does not default, the hedge fund pays $1 million over two years and receives nothing, resulting in a loss. The seller, in this case, earns the premium without making an initial investment.

The CDS position can also be liquidated before maturity. If the CDS spread widens, the buyer can sell protection at the higher market rate and realize a gain. If the spread tightens, the position may be closed at a loss, although the loss might be smaller than the loss that would have occurred by holding the position to maturity. In some cases, even small same-day changes in spreads can allow a trader to create a short-term profit by entering into an offsetting CDS position.

CDSs are also used in synthetic collateralized debt obligations. Instead of owning bonds or loans, a synthetic CDO gets exposure to a portfolio of fixed income assets through CDS contracts. These instruments are considered complex and opaque. One well-known example is Abacus 2007-AC1, which became the subject of a civil fraud case brought by the SEC against Goldman Sachs in 2010. Abacus was a synthetic CDO built from CDS contracts referencing mortgage-backed securities.

Naked Credit Default Swaps

A CDS in which the buyer does not own the underlying debt is called a naked CDS. Such contracts were estimated to account for a very large share of the market. There has long been debate in the United States and Europe over whether speculative CDS use should be banned.

Critics argue that naked CDSs should be prohibited because they resemble buying insurance on something you do not own. They compare it to buying fire insurance on a neighbor’s house, which creates perverse incentives. They also argue that naked CDSs enlarge the market beyond the actual amount of debt outstanding, increasing systemic risk. Because CDS contracts are synthetic, there is no theoretical limit to how many can be sold, so gross CDS exposure can exceed the amount of real bonds and loans by a wide margin.

George Soros argued for a complete ban on naked CDSs, calling them toxic and saying they allow speculation against companies or countries. Similar concerns were voiced by several European politicians during the Greek government-debt crisis, who accused naked CDS buyers of making the crisis worse.

Opponents of a ban, including former U.S. Treasury Secretary Geithner and CFTC Chairman Gensler, argued instead for better transparency and higher capitalization requirements. They believed naked CDSs still had a place in the market.

Supporters of naked CDSs say that short selling, including through CDSs, improves liquidity and makes the market more efficient. A more active CDS market can also help hedgers find counterparties more easily. Speculators may keep prices competitive and provide a useful signal to regulators and investors about the credit health of a company or country.

Germany’s market regulator BaFin found that naked CDSs did not worsen the Greek credit crisis. It also found that without CDSs, Greece’s borrowing costs would have been higher. In the United States, a bill had proposed giving a public authority the power to limit CDS use for purposes other than hedging, but the bill did not become law.

Hedging

Credit default swaps are widely used to manage default risk. A bank holding a loan may buy CDS protection to reduce the risk of borrower default. If the borrower defaults, the CDS payout offsets the loss on the loan.

Banks may also hedge by selling the loan or bringing in other participants, but those options may not be suitable. Selling the loan may require borrower consent, take time, and harm the bank-client relationship if the sale is interpreted as a sign of mistrust. By buying a CDS, the bank can keep the loan while laying off the credit risk. The drawback is that the bank may then have less incentive to monitor the borrower, and the protection seller may have no direct relationship with the borrower.

CDSs are also used to hedge concentration risk. If a bank is overly exposed to a particular borrower or industry, it can use CDSs to reduce that concentration without changing its actual loan portfolio. A seller of CDS protection can similarly diversify by taking exposure to industries where it has no lending relationship.

Banks may also use CDSs to free regulatory capital. By transferring credit risk, a bank may not need to hold as much capital against a loan, allowing it to make additional loans or redeploy resources elsewhere.

Hedging is not limited to banks. Pension funds, insurance companies, and bondholders may also buy CDSs to protect debt holdings. For example, if a pension fund owns five-year bonds of Risky Corp with a par value of $10 million, it can buy CDS protection on the same amount. If Risky Corp does not default, the fund pays premiums over the life of the contract, reducing return. If Risky Corp defaults after three years, the fund stops paying premiums and the seller compensates it for the loss, minus recovery. The fund still loses the premiums already paid, but avoids the much larger bond loss.

Large suppliers can also use CDSs as a proxy hedge for the credit risk of receivables. Although CDSs have been heavily criticized for their role in the 2008 financial crisis, many observers believe they still serve a useful hedging purpose.

Arbitrage

Capital structure arbitrage uses CDS contracts to exploit pricing differences between a company’s debt and equity. The idea is that a company’s stock price and CDS spread should usually move in opposite directions. If the company improves, the stock should rise and the CDS spread should tighten. If it worsens, the stock should fall and the CDS spread should widen.

Arbitrageurs try to profit when this relationship breaks down. For example, if bad news causes a company’s share price to fall sharply but its CDS spread does not move, an investor may buy CDS protection and buy the stock to hedge. The strategy profits if the CDS spread widens relative to the equity price.

The inverse relationship can sometimes fail, especially in leveraged buyouts. In such cases, CDS spreads may widen because the company will have more debt, while the share price may rise because buyers often pay a premium.

Another common arbitrage strategy compares the swap-adjusted spread of a CDS with the asset swap spread of the underlying cash bond. The difference is known as the basis. Basis trades attempt to profit from this difference, though they involve real risks that must be managed carefully.

History

Conception

Forms of credit default swaps existed at least as early as the 1990s, with early trades reportedly carried out by Bankers Trust in 1991. J.P. Morgan and economist Blythe Masters are widely credited with developing the modern CDS in 1994. In that case, J.P. Morgan had extended a large credit line to Exxon, which faced massive punitive damages related to the Exxon Valdez oil spill. The bank used CDSs to transfer the credit risk to another institution, reducing the regulatory capital it had to hold and improving its balance sheet.

Although early CDS transactions were successful, the market could not become truly profitable until the process was standardized and streamlined. JPMorgan later developed CDSs into securities through bundles sold to investors, and in 1997 it created BISTRO, a product that used securitization to split credit risk into smaller pieces. BISTRO is considered the first synthetic CDO. Regulators originally viewed this dispersion of risk favorably because it appeared to reduce concentration risk.

In 2000, CDSs became largely exempt from regulation by the SEC and CFTC under the Commodity Futures Modernization Act. At that time, CDSs were defined as neither futures nor securities and were therefore outside the traditional jurisdiction of those agencies.

Market Growth

At first, banks dominated the CDS market because they used CDSs to hedge lending exposures and free regulatory capital. By March 1998, the global CDS market was estimated at $300 billion, with J.P. Morgan holding a large share. Over time, however, hedge funds and asset managers entered the market, and by 2002 speculative participants had become the dominant players.

Growth accelerated as CDS documentation became standardized in 1999 and as the 1997 Asian financial crisis increased interest in sovereign debt protection. Index trading also grew rapidly after 2004. By 2003, the market had already reached $3.7 trillion, and by the end of 2007 it had climbed to $62.2 trillion. In 2008, portfolio compression reduced the notional amount to $38.6 trillion.

The market also created operational problems. In 2005, the New York Fed called major banks together because billions of dollars of CDS trades were being executed daily while record keeping was lagging by more than two weeks. This created serious legal and risk-management uncertainty. U.K. authorities had the same concerns.

Market as of 2008

Because defaults are relatively rare, most CDS contracts involve only premium payments and no actual default payout. Even with very large notional totals, the actual cash flow in a normal year is only a small fraction of the market’s full notional size.

Regulatory Concerns

After the collapse of Bear Stearns and later events in 2008, regulators became increasingly concerned about the CDS market. Bear Stearns’ widening CDS spread raised alarm, although some argued that the CDS market was merely reflecting Bear’s actual weakness rather than causing it.

The bankruptcy of Lehman Brothers triggered a huge notional amount of CDS payouts, though the net cash actually exchanged was much smaller because of netting. AIG also required a major federal loan after selling large volumes of CDS protection without sufficient hedging, leaving it exposed to potentially enormous losses.

Before 2008, CDSs were traded over the counter with no centralized exchange or clearing house. This lack of transparency led to widespread regulatory pressure for reform.

In November 2008, DTCC said it would begin releasing weekly data on outstanding CDS notional amounts. By 2010, Intercontinental Exchange’s clearing houses had cleared more than $10 trillion in CDSs. Clearing houses reduce counterparty risk by standing between the two sides of the transaction and spreading the risk. Some observers, however, warned that clearing houses could also create informational advantages for major market participants.

In 2009, the SEC granted an exemption allowing Intercontinental Exchange to guarantee CDSs. Around the same time, CME Group had not yet received the same approval. Regulators also approved ICE’s acquisition of Clearing Corp., which was owned by several major dealers. Member requirements for the ICE clearinghouse in March 2009 included a minimum net worth of $5 billion and an A-or-better credit rating.

Market as of 2009

By early 2009, several major changes had been introduced into the CDS market. Offsetting CDS trades could now be canceled, and many recent terminated contracts were removed from the market, reducing the notional amount to about $30 trillion by March. Globally, there were still enormous volumes of derivatives outstanding.

A key reform was central clearing in the United States and Europe. A clearing house acts as a central counterparty to both sides of the transaction, reducing default risk. Another reform was the standardization of CDS contracts to reduce legal uncertainty about payouts. These reforms were expected to improve transparency, encourage broader participation, and facilitate better trading.

In the United States, central clearing began in March 2009 under Intercontinental Exchange. In Europe, CDS index clearing began in July 2009 and single-name clearing started later that year. By the end of 2009, banks had regained much of their former dominance, and J.P. Morgan alone was estimated to hold about 30% of the global CDS market.

J.P. Morgan Losses

In 2012, hedge fund insiders became aware that J.P. Morgan’s Chief Investment Office had built very large CDS positions through trader Bruno Iksil, later nicknamed the “London whale.” Other traders, including a branch of J.P. Morgan itself, took opposing positions. The firm later reported major losses of about $2 billion. The trade was believed to involve a CDS index product related to major U.S. corporations.

Terms of a Typical CDS Contract

A typical CDS is documented under ISDA credit derivatives definitions. The confirmation names a reference entity, usually a corporation or sovereign with debt outstanding, and a reference obligation, often a bond or loan. It also specifies the effective date and scheduled termination date of protection.

The contract identifies a calculation agent, who handles successor entities, substitute obligations, and administrative calculations. In dealer-to-end-user contracts, the dealer is usually the calculation agent, while in dealer-to-dealer contracts, the protection seller usually fills that role.

The calculation agent does not decide whether a credit event occurred; instead, the occurrence must be supported by publicly available evidence and a credit event notice. Disputes are rare, though they can go to court if necessary.

CDS confirmations specify which credit events trigger payment obligations. Common events include bankruptcy and failure to pay. In North American investment-grade corporate and European corporate or sovereign CDSs, restructuring is usually included as a credit event, while it is typically excluded in North American high-yield trades.

The contract also sets deliverable obligation characteristics, which limit what debt may be delivered in physical settlement. Typical restrictions include that the obligation must be a bond or loan, have a maximum maturity of 30 years, be unsubordinated, not be subject to transfer restrictions beyond certain standard exceptions, be denominated in a standard currency, and not be subject to contingencies before maturity.

Premiums are usually paid quarterly, with standard dates falling on March 20, June 20, September 20, and December 20. Because these dates are close to IMM dates, they are often called IMM dates as well.

Credit Default Swaps and Sovereign Debt Crisis

The European sovereign debt crisis had many causes, including global finance, loose credit conditions during 2002 to 2008, the 2008 financial crisis, trade imbalances, real estate bubbles, the Great Recession, fiscal policy decisions, and the socialization of private losses through bank bailouts. The CDS market also gave early signals of stress in the sovereign crisis.

Since December 1, 2011, the European Parliament has banned naked CDSs on sovereign debt. During the 2012 Greek government-debt crisis, one major issue was whether restructuring would trigger CDS payouts. ECB and IMF negotiators tried to avoid triggering CDSs because doing so might have destabilized major banks that had sold protection. In some jurisdictions, restructuring has historically been treated differently because of the protections available under bankruptcy law.

Settlement

Physical or Cash Settlement

If a credit event occurs, CDS contracts are settled either physically or in cash. Under physical settlement, the protection seller pays par value and takes delivery of a debt obligation of the reference entity. Under cash settlement, the seller pays the difference between par value and the market price of the defaulted obligation.

For example, if a bond trades at 25 cents on the dollar after default, the seller pays 75 percent of par. The growth of the CDS market has meant that, for many companies, the notional amount of CDS contracts exceeds the amount of actual debt outstanding. Lehman Brothers is a famous example: it had about $155 billion of debt, but around $400 billion of CDS contracts referenced its debt. This made physical settlement impossible for all contracts and showed why cash settlement became necessary.

Auctions

When a major credit event affects a company with many outstanding CDS contracts, an auction may be held to settle a large number of contracts at once using a fixed cash settlement price. Dealers submit prices for the reference entity’s debt and requests for physical settlement. A second-stage Dutch auction follows, and the final clearing price becomes the settlement price for the CDS market. ISDA has said that this process has worked effectively for large events such as Lehman Brothers and Washington Mutual.

A long list of settlement auctions has been held since 2005, covering names such as Collins & Aikman, Northwest Airlines, Delta Air Lines, Delphi, Calpine, Dana, Dura, Movie Gallery, Quebecor World, Tembec, Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, Landsbanki, Glitnir, Kaupthing, Masonite, Hawaiian Telcom, Tribune, Republic of Ecuador, Millennium America, Lyondell, EquiStar, Sanitec, British Vita, Nortel, Smurfit-Stone, Ferretti, Aleris, Station Casinos, Chemtura, Great Lakes, Rouse, LyondellBasell, Abitibi, Charter Communications, Capmark, Idearc, Bowater, General Growth Properties, Syncora, Edshcha, HLI Operating Corp, Georgia Gulf, R.H. Donnelley, General Motors, JSC Alliance Bank, Visteon, Six Flags, Lear, MGM, CIT Group, Thomson, Hellas II, Naftogaz of Ukraine, FGIC, CEMEX, Aiful, McCarthy and Stone, Japan Airlines, Ambac Assurance, Truvo, Boston Generating, Takefuji, Anglo Irish Bank, Ambac Financial Group, Dynegy Holdings, Seat Pagine Gialle, PMI Group, AMR Corp, Eastman Kodak, Hellenic Republic, Elpida Memory, ERC Ireland, Sino Forest, Houghton Mifflin Harcourt, Residential Capital, Caesars Entertainment, Radio Shack, Sabine Oil & Gas, Alpha Appalachia, and Ukraine. Each auction produced its own final price as a percentage of par.

Pricing and Valuation

There are two major approaches to CDS pricing. The first is the probability model, which calculates the present value of expected cash flows weighted by the probability that default does not occur. The second is the no-arbitrage model, associated with Duffie, Hull, and White, which tries to ensure that no risk-free arbitrage opportunity exists.

Probability Model

In the probability model, CDS pricing uses several inputs, including the premium, the recovery rate, the credit curve, and the LIBOR curve. If no defaults occur, the contract’s price is simply the discounted sum of premium payments. Since default can happen at any time before maturity, the model assigns probabilities to each possible default timing and then computes the expected present value of the protection payment and the premium leg.

The probability of surviving a time interval without default is usually modeled using exponential decay based on the credit spread and recovery rate. The riskier the entity, the higher the spread and the faster the survival probability declines. The overall present value is then the sum of the expected protection payment minus the expected premium payments.

No-Arbitrage Model

The no-arbitrage model assumes that there is no risk-free arbitrage. Duffie uses LIBOR as the risk-free rate, while Hull and White use U.S. Treasuries. These models make simplifying assumptions, such as assuming there is no cost to unwind the fixed leg upon default. Even with these limitations, the Duffie approach is commonly used in the market for theoretical pricing.

Sensitivities

Similar to DV01 for bonds, CS01 measures the change in the market value of a CDS in response to a one basis point change in spread. CS01 may also be defined as the change in value resulting from a one basis point parallel shift in the credit spread curve. CS01 risk refers to unfavorable changes in value caused by changes in underlying credit spreads.

Criticisms

Critics argue that the CDS market became too large without adequate regulation and that, because contracts are privately negotiated, the market lacks transparency. Some also claim that CDSs worsened the 2008 financial crisis by accelerating the downfall of firms such as Lehman Brothers and AIG.

In Lehman’s case, the widening of CDS spreads may have damaged confidence and made the bank’s problems worse. Supporters of CDSs argue that the spreads simply reflected the bank’s real distress and that the market helped investors reduce their exposure to Lehman’s default risk.

CDSs were also criticized during the General Motors Chapter 11 process, where some bondholders may have had incentives to push the company into bankruptcy because they held CDS protection. Because CDS positions were not transparent, it was impossible to know who was long protection and who had written it.

At the time of Lehman’s collapse, some observers feared that CDS payouts of hundreds of billions of dollars could trigger more failures. In reality, the net amount exchanged was much smaller because many positions offset each other and because margins had already moved as spreads widened.

Many senior bankers later argued that the CDS market functioned reasonably well during the crisis and that the contracts distributed risk as intended. They argued that the real regulatory issue was not CDS itself, but the institutions and market structures surrounding it.

Warren Buffett famously described speculative derivatives as financial weapons of mass destruction. He wrote that unless derivatives are collateralized or guaranteed, their value depends on the creditworthiness of the counterparties. He also noted that profits and losses are often recorded before cash is exchanged. Despite his criticism, Berkshire Hathaway itself entered into large derivative transactions and said it had no counterparty risk because counterparties were required to post payments up front.

Monoline insurers also became involved in writing CDS protection on mortgage-backed CDOs, and some reports suggested this contributed to their downfall. MBIA later sued Merrill Lynch, alleging misrepresentation in connection with CDOs that induced MBIA to write CDS protection.

Systemic Risk

During the 2008 financial crisis, the counterparty risk embedded in CDS contracts became a major systemic concern, especially because firms like Lehman Brothers and AIG were involved in so many trades. If a fund had bought bonds and hedged with CDS protection from Lehman, then Lehman’s own failure would have destroyed the hedge. A later default by the bond issuer could have caused a major loss.

CDS chains can also form through netting. For example, company B may buy protection from company A and then sell protection to company C. If company A fails, company B may be unable to pay company C, creating a domino effect. Because CDS contracts are private, company C may not even know that its risk is linked to company A. Central clearing houses were proposed as a solution because they create a single central counterparty and reduce the domino problem.

Tax and Accounting Issues

The U.S. federal income tax treatment of CDSs has been uncertain. Commentators have suggested they may be treated as notional principal contracts or as options, depending on how they are drafted. The tax consequences can vary based on settlement type and trigger conditions. There is also a risk of CDSs being recharacterized as different financial instruments because they resemble put options and credit guarantees.

If a CDS is treated as a notional principal contract, periodic payments may be deductible and included in ordinary income. However, termination payments or payments received from selling the swap to a third party can raise unresolved tax questions. In 2004, the IRS said it was studying the issue. Later, in 2011, proposed regulations classified CDSs as notional principal contracts, which could give some termination and sale payments favorable capital gains treatment. Those proposals were criticized in hearings and in academic writing, especially as applied to naked CDSs.

Critics argue that naked CDSs are essentially gambling wagers and should therefore produce ordinary income in all cases. Congress previously confirmed that certain derivatives, including CDSs, count as gambling for some purposes by exempting them from state and local gambling laws. That exemption decriminalized naked CDSs under some laws, but it did not resolve federal gambling tax issues.

From an accounting perspective, CDS hedges can increase volatility because they are marked to market while the underlying loans or bonds may be carried at cost unless a significant loss is expected. Hedge accounting under FASB 133 may be available in theory, but in practice it can be difficult unless the CDS and the underlying exposure match closely.

LCDS

A newer form of default swap is the loan-only credit default swap, or LCDS. It is similar to a standard CDS, but the underlying protection is written on syndicated secured loans rather than the broader category of bonds or loans. For the most widely traded LCDS form in North America, the settlement method shifted in 2007 from physical settlement to auction settlement. The auction method is similar to other ISDA cash settlement auctions but does not require the parties to take extra steps after a credit event. The first LCDS auction was held in 2007 for Movie Gallery.

Because LCDS trades are linked to secured obligations that usually have higher recovery values than the unsecured bonds typically used in vanilla CDSs, LCDS spreads are usually tighter than CDS spreads on the same issuer.

ISDA Definitions

As the credit derivatives market grew rapidly, the 1999 ISDA Credit Derivatives Definitions were introduced to standardize CDS documentation. These were later replaced by the 2003 ISDA Credit Derivatives Definitions and then the 2014 ISDA Credit Derivatives Definitions. Each update was intended to make CDS payoffs more closely match the economics of the underlying reference obligations, especially bonds.