Credit Default Swaps (CDS) and Derivatives Soar into the Trillions of Dollars

A credit default swap is a contract whereby the seller of the swap agrees to make a payment to the buyer in the event of a specified event. That event is typically a default on a debt of some sort.

The buyer of the swap may purchase it with one upfront payment or with a series of payments over time. The seller is guaranteeing that a debt will not be defaulted upon. In return, the seller receives a fee rather like an insurance premium. This reduces risk on the part of the debt holder, who is the buyer of the swap. Hedge funds are common sellers of these swaps.

In fact, hedge funds, banks, insurance company subsidiaries and investment firms have generated immense amounts of credit swaps. Underwriting these swaps is a relatively easy way for hedge funds and financial institutions to generate lucrative fee income. Unfortunately, it also can be risky.

A swap transaction might look like this: 1) A pension fund manager purchases $100 million in high-yield, high-risk corporate bonds (“junk bonds”). The fund manager wants to enjoy the high rate of interest on the bonds, but since junk bonds frequently default, he decides to lay-off some of the risk with a swap. 2) A hedge fund agrees to underwrite a swap that will pay up to $50 million to the pension fund in the event that the pension fund incurs a loss on the bonds. The hedge fund collects a fee, which may range up to a few million dollars.

Money center banks, like JPMorgan Chase and Bank of America, along with major investment banks like Goldman Sachs, have been big buyers and sellers of such swaps. As one of the most popular types of financial derivatives, these swaps can be used to assume or lay-off the risk of many subunits of debt instruments, depending on the needs of the ultimate owner of the debt. Such slices of investments are often called “tranches.” Banks and investment firms have reaped immensely profitable fees from swaps.

Swaps bought by speculators are often known as “naked swaps” when the swap purchasers do not own the underlying bond or other debt instrument. A credit default swap is vaguely similar to a short sale of a stock. The buyer of the swap profits if the value of the debt instrument, which is insured by the swap, declines. As with short selling of stock, many swaps are purchased by speculators who do not actually own the debt instruments. This is a popular practice.

The Financial Accounting Standards Board (FASB) has issued stringent rules regarding how firms must account for and disclose their swap positions and risks. The SEC adopted a rule that defines regulation and those subject to it. They include companies, institutions and individuals transacting $8 billion or more of CDS-dealing transactions over the past 12 months, while security-based swaps of over $400 million are to be regulated. Most derivatives are to be exchange-traded and cleared through a central clearing house that covers losses in the event that a party to the trade defaults. These clearing houses are known as Swap Execution Facilities (SEFs). These SEFs are registered with the Commodity Futures Trading Commission (CFTB) and began trading in 2014. Contracts on indexes of CDS also became subject to the registration requirement. Another requirement is for traders to post a margin to ensure ready cash for payment to injured parties in the case of failure. The result of these rules could be lower prices due to exchange trading, but higher fees overall due to government scrutiny.

There is always some risk that the swaps could blow up. If a large number of corporations are unable to make timely payments on their debt instruments, or if substantial numbers of risks covered by swaps result in large losses, then the banks, insurance companies or hedge funds that have sold such swaps could find themselves struggling to pay off their obligations.

Meanwhile, derivatives of all types remain a massive, global market. Derivatives are so named because their value derives from underlying assets. These assets might be stocks, bonds, other debt instruments, commodities or some mutually agreed price index such as a stock index. Derivatives are used as a way of hedging risk or speculating on a future outcome.

Derivatives that are bought and sold on standardized terms are traded on large exchanges or over the counter (OTC). The most common derivatives include those covering foreign currency exchange contracts, interest rate contracts, equity (stock)-linked contracts, commodity contracts (covering such items as metals, oil and food stocks), as well as credit default swaps.

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Credit Default Swaps (CDS) and Derivatives Soar into the Trillions of Dollars, Business and Industry Trends Analysis

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