The Rise of Credit Default Swaps and Its Implications on Financial Stability

The Rise of Credit Default Swaps and Its Implications on Financial Stability

Fatma Sezer Dural (Beykent University, Turkey)
DOI: 10.4018/978-1-4666-6635-1.ch020
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Abstract

The credit default swap market has experienced an exponential growth in recent decades. Though the first credit default swap contract was negotiated in the mid-1990s, the market has enjoyed a surge of popularity beginning in 2003. By the end of June 2013, the outstanding amount reached 24.3 trillion dollars. It is mostly used to transfer or to hedge credit risk. Concurrently with the global credit crisis, several shortcomings in CDS markets have appeared. One of the obvious questions is whether they affect the stability of financial markets. In this context after broader exhibition of credit default swaps market, speculative use of CDS, inception of central counterparty, and transparency of CDS market is handled. As a conclusion, it is true that the CDS market still has some weaknesses, but it is no more prone to be destabilizing than other financial instruments. This is shown in this chapter.
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Credit Default Swap Fundamentals

A credit derivative is a financial contract between two parties that reduces credit risk of bonds or loans. Owing to the standardization of documentation and diversification of participants, credit derivatives have experienced a tremendous growth. The credit default swap (CDS) is the milestone of the credit derivatives market (JPMorgan, 2006).

A credit default swap is a financial agreement between two parties to exchange the credit risk of a reference entity. The buyer of the credit default swap, called protection buyer, usually pays a periodic fee, swap premium, in return for compensation for credit event of the reference entity. The seller of the credit default swap is called protection seller. The seller collects the periodic fee and makes contingent payment upon a credit event (JPMorgan, 2006).

Except protection seller, protection buyer and swap premium other basic elements of credit default swaps are, reference entity, obligation and credit events. The reference entity refers to the issuer of the debt instrument like a corporation, sovereign government or a bank loan. A credit event refers bankruptcy or failing to pay outstanding debt obligations. (Anson et al, 2004). Furthermore, ISDA (2014) defined six different types of credit event in its documentation. These are bankruptcy, obligation acceleration, obligation default, failure to pay, repudiation/moratorium and restructuring.

Key Terms in this Chapter

Clearing: Clearing refers to identify the obligations of all buyers and seller of CDS transaction. Clearing consists of reporting, monitoring, margining of risk, netting of trades, tax and default handling process.

Derivatives: Are financial instruments whose value is determined depending upon the underlying assets like stocks, bonds, currencies and market indexes. It may consist of one or more underlying assets. Futures, options, credit default swaps are examples of derivatives.

Central Counterparty: A central counterparty is a financial organization that acts as an intermediary in derivatives and equity markets through bearing the responsibility of becoming buyer to every seller and seller to every buyer. Its aim is to reduce the amount of counterparty risk by absorbing the loss in the case of default.

Stability: States a condition in which financial intermediaries, markets and market infrastructures are resistant to financial shocks and operating smoothly.

Credit Default Swap: CDS is a bilateral financial contract that is used to hedge or transfer credit exposure of a reference entity. The buyer of a credit default swap receives credit protection in return for paying a periodic fee to the seller. The seller of the credit default swap collects these payments and profits if reference entity doesn’t default.

Counterparty Risk: is a kind of risk occurs in the case that one side of a CDS contract defaults to meet its obligations.

Transparency: Availability of full access to any required financial information such as price, financial reports. it requires timely, meaningful and reliable disclosures.

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