Where Can I Buy Credit Default Swaps?

Credit Default Swaps (CDS) are financial agreements that allow one party to transfer the credit risk of a debt instrument to another party. These instruments function much like insurance, providing a way to protect against the possibility that a borrower might fail to meet their payment obligations on a loan or bond. This protection can be particularly appealing to those holding debt instruments who wish to mitigate potential losses from a credit event.

What a Credit Default Swap Is

A Credit Default Swap is a contract between two parties: a protection buyer and a protection seller. The protection buyer makes periodic payments, similar to insurance premiums, to the protection seller. These payments are exchanged for the seller’s promise to compensate the buyer if a specific “credit event” occurs involving a designated third party, known as the reference entity. The debt instrument covered by the CDS is called the reference obligation, which is typically a senior unsecured bond.

A credit event is a trigger that obligates the seller to make a payout. Common credit events include bankruptcy, failure to make payments on the debt, or debt restructuring that disadvantages creditors. If a credit event occurs, the protection seller typically pays the buyer the face value of the reference obligation, or the difference between its par value and current market price, effectively covering the loss. The buyer, in turn, may deliver the defaulted bond to the seller. CDS contracts usually have a defined maturity, typically around five years.

Who Trades Credit Default Swaps

Credit Default Swaps are primarily traded by large institutional investors. Major participants in this market include banks, hedge funds, and insurance companies. These institutions engage in CDS transactions for various reasons, such as hedging existing credit exposures. For instance, a bank might buy CDS protection to offset the risk of a loan defaulting, allowing them to manage risk while retaining the loan in their portfolio.

Beyond hedging, these institutions also use CDS for speculative purposes or to gain synthetic exposure to certain credit risks. Hedge funds, for example, might use CDS to bet on the creditworthiness of a company without actually owning its bonds. Insurance companies also participate, both buying protection to mitigate risk on their bond holdings and selling CDS to generate investment income.

How Credit Default Swaps are Traded

Credit Default Swaps are predominantly traded in the over-the-counter (OTC) market. Transactions are privately negotiated directly between two parties, rather than occurring on a centralized public exchange. The OTC nature allows for customized terms tailored to the specific needs of the institutional participants involved. However, this bilateral negotiation also introduces counterparty risk, which is the risk that one party to the contract might default on its obligations.

To address counterparty risk and enhance market stability, a significant portion of standardized CDS contracts are now centrally cleared. Central clearinghouses act as intermediaries, guaranteeing the terms of the trade even if one party defaults, thereby mitigating risk for market participants. These clearinghouses pool exposures and reduce the overall credit exposure in the market. Individuals might gain indirect exposure through specialized investment vehicles like certain exchange-traded funds (ETFs) or mutual funds that include CDS in their portfolios.

Oversight of Credit Default Swaps

The regulatory framework for Credit Default Swaps in the United States involves the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Following the 2008 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 introduced significant reforms. This legislation aimed to improve accountability and transparency in the financial system.

The Dodd-Frank Act mandated central clearing for certain types of CDS contracts and introduced new reporting requirements. For instance, all swap transactions involving a U.S. person are now generally required to be reported to a swap data repository, providing regulators with greater insight into market activity and potential systemic risks. The SEC regulates CDS on single names and narrow-based security indexes, while the CFTC oversees CDS based on broad-based security indexes. This oversight focuses on systemic risk reduction and market stability, reflecting the institutional nature of the CDS market.