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Credit Default Swaps

For greater political repercussions, however, one must look to another area of the swaps market. That area is Credit Default Swaps (CDS). Representing the youngest of the major derivative securities, CDS originated in the early 1990s as a small private market in which the underlying assets chiefly consisted of corporate debt.[1] Not until 2001 does the ISDA lists statistics for CDS, when the notional value outstanding was $631.5 billion.[2] It was around this time that CDS based on sovereign

CDS market by notional value, 2001-2014. Source

Fig. 6.11 CDS market by notional value, 2001-2014. Source: ISDA and BIS

debt emerged. By 2014, CDS had grown into a $16.4 trillion market, though that was noticeably down from the peak of 2007 (Figure 6.11).[3]

Revolving around a bond or some other type of loan, a CDS is a contract where one party agrees to make regular payments over a number of years to another. This is on the understanding, mind you, that the latter party receiving the payments will guarantee the principal of the debt should a so-called credit event take place. A credit event is defined as a bankruptcy, default, repudiation, moratorium, or restructuring on the part of the lender that significantly impairs the value of the debt. When this happens, the party making the regular payments, also called the protection buyer, is entitled to deliver the bond to the counterparty, the protection seller, and receive the principal value. Alternatively, CDS can be cash-settled. In that scenario, the protection buyer receives from the protection seller the difference between par value and the current market value of the debt security.

That a credit event has in fact occurred is not always certain. An illustration of this occurred in early 2012 when Greece restructured its debt. The country offered its creditors new debt securities in exchange for the bonds they were currently holding.[4] As the new debt carried a lower principal, the bond holders were essentially being asked to accept a loss. European politicians trying to contain the sovereign debt crisis hoped that the voluntary nature of the request would keep the ISDA, which decides whether or not a credit event has transpired, from declaring such an event. As it turned out, the ISDA saw through the pressure that the Greek government put on bond holders to accept the deal. In thus triggering CDS payouts, the Greek situation illustrated how CDS provides insurance to financial market players holding bonds or loans containing risks to which they would prefer not be exposed. In the meantime, CDS prices continually vary as perceptions about the credit quality of the underlying entity shifts among market participants. By playing on these price movements, CDS can be employed to bet on whether or not a government or corporate borrower is going to run into financial distress.

When swaps promise to assist governments to veil their debt and deficits, they hearken to them. But when swaps are used to hold governments to account for their debt and deficits, it is a very different matter. CDS exemplifies this unsurprising contradiction. When CDS prices on Southern European bonds soared from 2010 and into early 2012, what especially irked politicians in places like Greece and Portugal, as well as those in the Northern part of the continent trying to quell the Euro sovereign debt crisis, were so-called naked positions. One is said to be naked on CDS if one has taken a position on the swap contract without also having a stake in the underlying security. So irked were European politicians with this form of derivative trading that they banned naked CDS positions.[5] Thanks to that ban, the CDS market on European government bonds has practically disappeared.[6] The rationale for the ban was that trading in naked CDS enables speculators to herd against a particular country’s bonds, forcing it to pay higher yields than a reasonable observer would judge. European politicians insisted that this is precisely what bedeviled countries like Portugal and Greece. This, in turn, made it more challenging for the economically healthier part of the EU to supply those countries with assistance.

Whatever doubts may have initially been entertained about the scale of the debt problems faced by southern European nations, these were certainly dispelled with the passage of time. CDS did not create or exacerbate the Euro sovereign debt mess. It merely alerted people to it and reflected the turmoil. Were democratic states not so prone to running up huge debt, the CDS market for government bonds would never become highly active. The real problem is why the CDS market did not provide an earlier warning. In this respect, it imitated the shortcomings of the government bond market, which the CDS market for sovereign issuers closely mirrors. Whether it comes later rather than sooner, however, the information conveyed in CDS prices about the financial status of bond issuers is very helpful to economic agents in making their calculations and decisions. When the issuer happens to be a state, it serves as a check on the government’s pursuit of unwise policies. Without the ability to take naked CDS positions, traders and investors with a negative view of a sovereign issuer will otherwise be left to express it on the bond market. Shorting bonds, though, is harder than trading CDS. For this reason, information is apt to be impounded first in the CDS market and then subsequently flow to the bond arena.[7] Restricting the information flow to the bond markets means governments can go on being irresponsible longer.

Exhibit A in the case for beefing up regulation of derivatives is AIG. For decades, AIG had been a global player in the insurance business operating in well over a 100 countries. In 2004, the company reached the pinnacle of corporate America by becoming a constituent of the Dow Jones Industrial Average. Just four years later, however, the company found itself on the brink of bankruptcy. A London-based affiliate had built up a huge CDS business insuring debt instruments with a notional value of about $533 billion. A good part of this portfolio was written against sub-prime mortgage securities.[8] Once these securities came under pressure with the collapse of the US real estate market, the company was forced to post more collateral with the counterparties to their CDS contracts. As conditions in the sub-prime arena grew more critical in September 2008, AIG became unable to meet the escalating demands for additional collateral. Since the company was insuring significant holdings of numerous investment and commercial banks, the US government feared that the collapse of AIG would spread the financial equivalent of a deadly virus throughout the entire system were it to default on its CDS obligations. As a result, the government came to the rescue of AIG, eventually backstopping its CDS positions to the tune of $182 billion.[9] The immediate beneficiaries of this were actually the company’s counterparties. These included a number of European banks as well as bulge bracket investment banks like Goldman Sachs, which received $2.9 billion straight to its bottom line.[10]

Once again, as a consequence, we saw an historical pattern repeated. That is, new regulations tend to come in large doses all at once after a dramatic event changes the political calculus. Thus, the AIG debacle gave rise to provisions in the 2010 Dodd-Frank targeting the derivatives industry. Before this, not even the 1998 collapse of Long-Term Capital Management, a hedge fund that was heavily invested in interest rate swaps, managed to bring the weight of the state heavily into the derivatives space. Part of the 2010 Dodd-Frank Act, however, encompassed various edicts relating to derivatives. The chief provision consisted of a directive to move more trading activity onto exchanges away from OTC venues.

This return to the old order will not work. The Dodd-Frank mandate is premised on the idea that exchanges offer the benefit of a clearing agency. What a clearing agency does is act as a third party standing between the two counterparties to a trade, guaranteeing that the terms of the derivatives contract are fulfilled. It does this by ensuring that traders put up sufficient collateral to support their positions given prevailing market conditions. It also periodically transfers money between traders’ accounts to reflect price movements. Should one of the parties default on their side of the deal, the clearing agency is required to pay the other party what they would have otherwise been entitled to receive on the transaction. With such an agency checking that derivative trades are appropriately backed up, the government’s hope is that there will not be another AIG beguiled by all the money coming their way for providing CDS insurance. The hope, too, is that the presence of a clearing agency will calm nerves whenever markets get tempestuous. Financial institutions could thereby be prevented from calling in all their credits at counterparty firms out of a concern for their own viability.

But it is not as if derivative disasters have never occurred on exchanges. What Nick Leeson did in bringing down Barings was the result of futures and options trades executed on the Singapore International Monetary Exchange and the Osaka Stock Exchange. In 1996, Sumitomo took a $2.6 billion loss on copper futures traded on the London Metals Exchanges. Ten years later in 2006, Amaranth Advisors LLC, suffered a $5 billion loss trading natural gas futures on the NYMEX.[11] In addition, a major reason why OTC market volumes dwarf those transacted on exchanges is that the customization of contractual terms that is more workable in the former venue is seen a huge benefit by market participants. To the extent that liquidity is reduced in the OTC market in favor of exchanges, such tailor- made transactions are going to be tougher to realize.

More ominously, though, is the prospect that a few clearing agencies, in light of the consolidation we are witnessing among exchanges, will hold sway in the industry.[12] Derivatives risk will be concentrated, just as it was with AIG, rather than dispersed. Should one of those agencies run into trouble, the government will be hard-pressed not to offer a bailout. Where the bulk of derivative trading is politically directed to exchanges, the clearing houses will become too big to fail. Of all the ways that politics now skews the derivatives markets—stimulating and convulsing these mainly through monetary and fiscal profligacy—nothing is scarier than this. As a by-product of its own evolutionary logic, democracy spurred the buildup of a ginormous betting ring. It is now on the verge of guaranteeing all the bets.

  • [1] Gillian Tett tells the story of how the CDS came about at J.P. Morgan in Fools Gold Howthe Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed andUnleashed a Catastrophe (New York: Free Press, 2009), 47-48.
  • [2] ISDA, “ISDA Market Survey Historical Data”,
  • [3] BIS, “Semiannual OTC Derivatives Statistics” (November 5, 2015),
  • [4] ISDA, “Greek Sovereign CDS”,
  • [5] Alex Barker, “EU ban on naked CDS to Become Permanent”, Financial Times (October19, 2011),
  • [6] Serena Ruffoni, “Wherever Did Europe’s Sovereign CDS Go?” The Wall Street Journal Moneybeat, (January 31, 2014), wherever-did-europes-sovereign-cds-trading-go/
  • [7] Rene M. Stulz, “Credit Default Swaps and the Credit Crisis”. The Journal of EconomicPerspectives (2010), 75-76.
  • [8] Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Commission Report(Washington: US Government Printing Office, 2011), 139-141,
  • [9] Robert W. Kolb, The Financial Crisis of our Time., 117-124; Financial Crisis InquiryCommission, The Financial Crisis Inquiry Commission Report, 350.
  • [10] Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Commission Report.
  • [11] Laurent L. Jacque, Global Derivative Debacles, 47-72; 97-102; 143-177.
  • [12] The Economist, “Centrally Cleared Derivatives: Clear and Present Danger”, (April 7, 2012),
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