Credit Default Swaps and Systemic Risk

Publié le par Roxane Zaïm

The credit default swaps (CDS) market has grown very substantially since the late 1990s. It was presented as the new instrument for banks to manage their risk more properly, thus contributing to financial stability. However, the CDS market has been blamed as one of the causes of the credit crisis. The financial crisis has revealed that this market is under regulated and that it could increase systemic risk in the financial system.


Overview of the CDS market


In the past, banks and other institutions used to manage their credit risk by themselves; they had no other choice to "wait and hope for the best". Now, they can manage their portfolios of credit risks. through the market of credit derivatives.  The CDS market is the most common credit derivative (an agreement that shifts risk from one party to another). It is a contract which provides insurance against default risk by one company (or governement) from another market participant. In an event of default (late payments, bankrupcy, etc), the protection seller would have to compensate the losses of the protection buyer. In return, the protection buyer pays a periodic fee to the protection seller. The CDS is equivalent to default insurance contracts. Thanks to CDSs, banks can diversify their credit risks and manage their credit exposure.


Basic CDS overview


Source: European Central Bank (ECB)

This chart describes the relationship between CDS protection buyer and CDS protection seller in case of no credit event or after credit event.


The CDS market allows the hedging and securitization of credit risk. The holder of an asset and the holder of the risk are two different agents. The potential risk factors (delinquency, default, interest rate fluctuations, and exchange rate movements) can be transferred from one to another.


Source : Bank for International Settlements (BIS)

The global CDS outstanding notional amount increased up to 2007 when it reached a peak of $58 trillions in December 2007. Since then the CDS market has apparently experience decreasing trend since mid 2008. But this decline is probably associated with statistical improvement (end of double-counting).


For the protection buyer, the main benefits and problems of CDS are the following:

Benefits of the CDS market

- CDS allows companies to hedge their exposure to credit losses.

- CDS can be used to hedge a position in a corporate bond. The CDS transforms the corporate bond to approximately a “risk-free bond”.

- The CDS market enables the diversification of the loan portfolio. The CDS reduces credit constraints by dispersing risk.

- The CDS market is a risk management tool (credit risk is distributed, measured, and managed), which provides rational credit pricing and greater liquidity.

- CDS spreads have been used as an indicator of distress during the financial crisis. CDS spreads provide a measure of default risks (indicating probability of default).


Problem with CDS

- A CDS transfers risk from agents with high skills in credit risk management (banks) to actors with less skills and less experience (insurers or hedge funds).

- Market participants are concentrated. The five largest CDS dealers (1) were counterparties to almost 50% of the CDS trades. This concentration increases the systemic risk.

- CDS reduce the incentives of banks to take caution regarding credit quality as they have apparent protection against "toxic" credit (moral hazard)


According to Warren Buffet, derivatives are “financial weapons of mass destruction”. The CDS has a moral hazard effect because with such credit protection, banks have become more indifferent to risk.  

The lack of information and uncertainty about credit risk are also weaknesses of CDS. The CDS can therefore increase systemic risks.


Why do CDS create systemic risks?


The CDS can be used to hedge risks but also to speculate. This creates a paradox in the financial markets: the CDS market offers increased protection but it can also be an additional source of systemic risk. Systematic risk refers to possibilities of propagation of default among financial institutions during a short period of time often caused by a single major even (default). For example, a bankruptcy can lead to many others and force the central bank to intervene to stop the contagion. Systemic risks have declined this year as some indicator suggest (Global financial stability report, IMF, 2009). However, credit risks remain high and indicators of financial stress elevated.


The CDS market generates operational risks: the infrastructure of the market was not able to support the rapid market growth as the volume of CDS was too great and trade processing became a problem. It is estimated that around 10 percent of credit derivatives transactions are unconfirmed and failed trades. There are also reporting problems because some data are not available, or saved using different methods (electronically or manually). It is one of the reasons for non efficiency of these transactions’ reporting and monitoring.


Another important problem is the concentration of market participants in the CDS market, which can create systemic risks. For example, if the protection seller fails and is unable to repay its obligations, the bankruptcy would affect other dealers because they have contracting CDS with this institution. There is a potential risk that they cannot all hedge their positions. The shock can be transmitted to other markets. For instance, after the bankruptcy of Lehman Brothers (15/09/2008), an important protection seller, the U.S Federal Reserve intervened to prevent a potential contagion. 


CDS products are becoming more and more complex and in this way it is more difficult to evaluate the associated risk. Portfolios are structured with interrelated CDS. For example, counterparties can have offsetting bilateral contracts, which mean that new contracts are written by counterparties instead of existing contract being closed out. This kind of contract has been less used since 2007.  


The lack of disclosure of the CDS has created a potential threat to banks' stability. It is hard to measure the quantity held by each bank. There is also a lack of transparency about this market which generates suspicion. Following this event, there has been a lot of difficulty to reestablishing the status of the CDS market. Indeed, the confidence of the market participants in the CDS market is of fundamental importance. The failure of Lehman Brothers created a potential systemic risk, market participants did not expect this bankruptcy.


Central banks and other institutions find it extremely difficult to effectively regulate CDS trades. Strategies used by the protection buyer sometimes lead to manipulate CDS spread to generate a profit on the price of CDS. For example, a company can simulate difficulties in its activities to reduce the price of CDS (pushing out CDS spread). These strategies have been efficient since market participants are very sensitive to changes in the volatility of CDS prices.


The weaknesses of CDS market need to be corrected to allow better efficiency in this market. To prevent the CDS market from a potential systematic risk, large interventions are necessary.


Solutions to implement

The CDS market can negatively affect financial stability. The two main solutions are: (a) improving market integrity, and (b) enhancing transparency / disclosure in financial reporting and transaction data.

The development of market integrity corresponds to the removal of the manipulation of CDS prices created by market participants. Currently, they can manage the CDS spread to increase their opportunities to make profit. Market abuse can be blocked by regulation or the enforcement of the current rules. Another problem with the CDS is that bilateral trade occurs without any traditional disclosure regulation. Authorities do not have the power to efficiently monitor this market. Market participants are not clearly identified and their trading behavior cannot be anticipated (due to a lack of information). Hedge funds also need to be regulated on their trade of CDS. The international reforms must be allocated to a specific authority with a specific remit and a global view of this market. This reform requires the coordination of all countries, but there is currently a problem of low international cooperation. If regulations are dealt with at the national level, transparency will be less and a potential systemic risk remains. Reforms of financial regulation will improve pricing valuation and decrease opportunities to abuse the system. The European Commission has already announced a draft European Union derivatives law for July 2010. Credit derivatives will be regulated by reducing the risks and improving transparency. The plan will take effect at the end of 2012.

Financial institutions can develop new and more sophisticated CDS, which will remain opaque and risky. One of the problems is the structure of credit products which are varied and not classified. According to both International Financial Reporting Standards (IFRS) and the US Generally Accepted Accounting Principles (GAAP), credits derivatives should have an accounting framework with detailed standards of disclosure and an analysis of off-balance sheet credit exposure. The CDS must be described through tabular representations of data explaining their profits and losses.

Since 2008, the SEC (Securities and Exchange Commission) and FASB (Financial Accounting Standards Board) have created new rules to increase CDS information and to improve transparency. The collection and monitoring of the evolution of data is a crucial importance for the CDS Audit. But the exchange of CDS transactions data between the Authorities and DTCC (The Depository Trust & Clearing Corporation) needs to be improved. It is important that there is synchronization and exchanges of CDS transaction data at the national and international level.

Several initiatives have been started in many countries in order to tackle all these problems. The most important has been the movement of "clearing" (ie netting the different positions of market participants in order to avoid double counting and to centralise data).



The CDS represent an important innovation for global financial markets. It has become a reference market for managing and measuring credit risk. The advantage of CDS is that they enable efficient risk management. However, their disadvantage is that they are an instrument for speculative operations and can potenbtially create systemic risk. The framework of CDS needs to be improved to provide better transparency and information. In this respect, key changes are expected to take place over the coming quarters.




ECB, Credit default swaps and counterparty risk, August 2009

IMF Report, Global Financial Stability Report, Navigating the Financial Challenges Ahead,
October 2009

John Kiff, Jennifer Elliott and al., Credit Derivatives: Systemic Risks and Policy Options; IMF Working Paper 09/254; November 2009


Michel Aglietta, Financial Market Failures and Systemic Risk, CEPII, Document de travail n° 96-01, 1996


René M. Stulz, Credit Default Swaps and the credit crisis, NBER Working Paper Series, Number 15384, September 2009


Tim Weithers, Credit Derivatives: Macro-Risk Issues Credit Derivatives, Macro Risks, and Systemic Risks, University of Chicago, 2007


(1) JPMorgan, Goldman Sachs Group, Morgan Stanley, Deutsche Bank , Barclays Group

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