🔍 Definition:
A Credit Default Swap (CDS) is a financial derivative contract where one party (the buyer) pays a periodic fee to another party (the seller) in exchange for protection against the default of a third-party borrower (the "reference entity").
It works like insurance against credit events like default, bankruptcy, or debt restructuring.
🏦 How It Works:
| Party | Role |
|---|---|
| CDS Buyer | Pays regular premiums and receives compensation if the reference entity defaults |
| CDS Seller | Collects premiums and pays if the credit event occurs |
| Reference Entity | The third party whose default triggers the payment |
📌 Example:
-
You own bonds issued by Company X.
-
You buy a CDS from Bank A to protect against default.
-
If Company X defaults, Bank A pays you the bond’s face value.
✅ Purposes of Using CDS:
-
Hedging credit risk (especially for banks and bondholders)
-
Speculating on a company’s creditworthiness (without owning the debt)
-
Pricing credit risk in the broader market
⚠️ Risks with CDS:
-
Illiquidity during crisis periods
-
Complexity in pricing
-
Legal and regulatory issues
-
Counterparty risk (see below)
🔄 What is Counterparty Risk?
🔍 Definition:
Counterparty risk is the risk that the other party in a financial contract will default on its obligations.
In the context of CDS, the main concern is:
“What if the CDS seller (the protection provider) also fails?”
📌 Example:
You bought CDS protection from Lehman Brothers in 2008.
When the reference company defaulted, Lehman Brothers itself went bankrupt, so you didn’t get paid — a classic case of counterparty risk.
💣 Why Counterparty Risk Matters:
-
Financial instruments like CDS are OTC (over-the-counter) — not traded on exchanges
-
No central clearing = direct dependence on the counterparty
-
Domino effect: one default can trigger others (systemic risk)
🧰 How to Manage Counterparty Risk:
| Strategy | Description |
|---|---|
| Collateral Requirements | Requiring parties to post collateral reduces exposure |
| Central Clearing | Using clearinghouses (like LCH, ICE) to guarantee trades |
| Credit Limits | Capping exposure to any single counterparty |
| Netting Agreements | Reducing gross exposure by offsetting mutual positions |
| Monitoring Credit Ratings | Active surveillance of counterparties' creditworthiness |
📚 Conclusion
-
A CDS is a tool for managing credit risk — like an insurance policy against default.
-
However, counterparty risk in CDS deals is critical — especially in crises when the protection provider may also collapse.
-
Strong risk management frameworks and regulatory oversight are key to safe CDS usage.