What Is a Credit Default Swap (CDS)?

What Is a Credit Default Swap (CDS)?

Let me explain what a credit default swap, or CDS, really is. It's a financial derivative that lets you, as an investor, swap or offset your credit risk with someone else. You, the protection buyer, purchase a CDS from a protection seller who agrees to reimburse you if the borrower defaults.

Most CDS contracts involve ongoing premium payments, much like insurance policy premiums. If you're a lender worried about a borrower defaulting on a loan, you can use a CDS to offset that risk directly.

Key Takeaways

A CDS is a derivative that transfers credit exposure from fixed-income products. In the contract, you pay ongoing premiums like insurance, and in return, the seller pays the security's value and interest if a default happens. You can use CDSs for speculation, hedging, or arbitrage. They played a big role in the 2008 Great Recession and the 2010 European Sovereign Debt Crisis. As of the first quarter of 2025, the U.S. CDS market is about $4.2 trillion, which is 82% of the credit derivatives market.

How Credit Default Swaps Work

A CDS is a derivative contract that shifts credit exposure on fixed-income products, which could be bonds or securitized debt like derivatives of loans sold to investors. For instance, if a company sells a bond with a $100 face value and 10-year maturity, it agrees to repay the $100 plus regular interest. Since the issuer can't guarantee repayment, you as the investor take on credit risk. You can buy a CDS to transfer that risk to another party who pays you if the issuer defaults.

You pay premiums to the CDS seller until maturity. In exchange, if a credit event qualifies, the seller pays you the security's value plus interest from the event to maturity. Debt securities often have long terms, like 30-year mortgages, making risk hard to estimate—that's why CDSs are popular for managing it.

Credit Default Swaps and Credit Events

A credit event triggers settlement in a CDS, and these are agreed upon at purchase as part of the contract. Common triggers for single-name CDSs include defaults other than failure to pay, actual failure to pay, obligation acceleration where debts must be paid early, repudiation of contract validity, moratoriums suspending the contract, obligation restructuring, and government interventions affecting the contract.

Size of the Credit Derivatives Market

The U.S. Office of the Comptroller of the Currency reports quarterly on credit derivatives. In their Q1 2025 report, the entire market was $5.1 trillion, with CDSs making up $4.2 trillion or 82% of it.

Terms of a CDS

CDSs don't have to cover an investment's full lifetime if you're using them for insurance. Say you're two years into a 10-year security and suspect credit trouble—you could buy a five-year CDS to protect until year seven, when you think risks will ease.

Settlement

On a credit event, settlement can be physical, where the seller gets the actual bond from you, or by cash, which became preferred as CDSs shifted to speculation. In cash settlement, the seller pays your losses.

When Are CDSs Used?

CDSs serve as insurance against credit events on assets and are used for speculation, where you trade them to profit from price differences; hedging, like a bank buying one to protect against borrower default; and arbitrage, buying a bond in one market and a CDS on the same entity in another.

The Great Recession

CDSs were central to the credit crisis leading to the Great Recession. Firms like AIG, Bear Stearns, and Lehman Brothers issued them to protect against defaults on mortgage-backed securities, which are bundled mortgages sold as shares. Investors thought CDSs eliminated risk as housing prices rose, but when prices collapsed, these firms couldn't pay obligations, causing global market turmoil and the 2007–2008 crisis.

Mechanics of Credit Default Swaps

Settlement mechanics include physical, where you deliver the debt securities to the seller for the notional amount, or cash, based on an auction to price the defaulted securities. Cash is preferred when bond liquidity is low.

Advantages and Disadvantages of CDSs

CDSs help with risk management by hedging against defaults on bonds or portfolios, allow portfolio diversification without owning bonds, enhance liquidity for quick position changes, offer speculation on credit markets, and can be customized to your needs. On the downside, they expose you to counterparty risk if the seller defaults, are complex and opaque, lack strong regulation leading to less transparency, and can become illiquid in stress, making exits costly.

Credit Default Swaps and Counterparty Risk

Counterparty risk is the chance the other party defaults on the CDS, traded over-the-counter without exchange oversight. If the seller can't pay on a credit event, you face full risk. Manage it by due diligence on counterparties, diversifying trades, and using collateral agreements.

Frequently Asked Questions (FAQs)

What triggers a CDS? The seller pays if a qualifying credit event like a loan default occurs, covering the security's value plus interest. Is a CDS legal? Yes, regulated by the SEC and CFTC under Dodd-Frank. What are the benefits? Mainly hedging risk with insurance-like protection or speculating on credit quality.

The Bottom Line

CDSs mitigate default risks on assets like mortgage-backed securities and fixed-income products, but their heavy use contributed to the 2007–2008 crisis and 2010 European debt crisis.