Here’s what credit default swaps means

Credit default swaps have come under scrutiny as a result of the turbulence in Europe’s banks that followed the collapse of 167-year-old Credit Suisse CSGN.S and runs on regional banks in the United States.

Investors have hammered the shares and bonds of some of Europe’s most recognisable financial brands, including Deutsche Bank DBKGn.DE, Germany’s largest lender, out of concern over which bank would be the next.

The actions came after a spike in the price of credit default swaps (CDS), which are used to insure against default on debt held by Deutsche Bank, to a more than four-year high last week.

The volatility of Deutsche Bank’s instruments, particularly CDS, was cited by Andrea Enria, the head of banking supervision at the European Central Bank, as a concerning indication of how readily investors could be alarmed.

There are markets like the single-name CDS market that are extremely opaque, extremely shallow, and extremely illiquid, and with just a few million (euros), the worry travels to the banks with trillions of euros worth of assets and taints stock prices as well as deposit withdrawals.

Credit default swaps are derivatives that provide protection from the possibility that a bond issuer—such as a business, a bank, or a sovereign government—will fail to make payments to its creditors.

Bondholders anticipate receiving interest and their original investment back when the bond matures. They must take the risk of holding that debt because they have no assurance that one of these things will occur.

By offering some sort of insurance, CDS assists in reducing the risk.

The International Swaps and Derivatives Association estimates the CDS market to be worth $3.8 trillion. Yet, according to ISDA data, the market remains much below the $33 trillion it reached during its peak in 2008.

In comparison to the equity, foreign currency, or global bond markets, where there are more than $120 trillion in outstanding bonds, the CDS market is modest. According to figures from the Bank for International Settlements, the average daily volume of foreign exchange is close to $8 trillion.

These derivatives can have sporadic trading. According to data from the Depositary Trust & Clearing Corporation, even for large corporations, the average daily number of CDS trades can occasionally be in the single digits (DTCC).

Due to this, it is difficult to manage the market, and even a little CDS trade can result in a significant price change.

Through an intermediary, frequently an investment bank, investors in bonds issued by corporations, banks, or governments can purchase CDS insurance. The investment bank locates a financial institution to issue an insurance policy on the bonds. These transactions are “over-the-counter,” meaning they bypass a central clearing house.

The counterparty will get a regular fee from the buyer of the CDS and will thereafter assume the risk. In exchange, much like an insurance payout, the seller of the CDS pays out a specific sum if something goes wrong.

Credit spreads, which represent the amount of basis points that the derivative’s seller costs the buyer in exchange for offering protection, are used to quote CDS.

A “credit event,” such as the bankruptcy of a debt issuer or the non-payment of bonds, might cause a CDS payout to occur.

To allay investor worries that CDS would not cover actions made by governments to aid distressed companies, especially banks, a new category of credit event known as “Governmental Intervention” was launched in 2014.

CDSs are actively traded, just like any other financial asset. Demand for a debt issuer’s CDS rises as risk perception around it does, increasing the gap.

The government sector is the largest market for CDS. According to DTCC data, Brazil leads the list with $350 million in daily notional average trades.

According to DTCC data, Credit Suisse’s CDSs saw the greatest activity on the corporate front in the final quarter of 2022, with $100 million exchanged daily.