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Simple English definitions for legal terms
credit default swap
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A quick definition of credit default swap:
A credit default swap (CDS) is a type of contract where two parties exchange the risk that a borrower will not be able to pay back their debt. The buyer of a CDS pays the seller a fee, and in exchange, the seller agrees to pay the buyer a lump sum if the borrower defaults. For example, if someone buys a CDS for a company's bonds, they are protecting themselves in case the company goes bankrupt and can't pay back the bonds. However, buying a CDS also carries its own risks, as the seller of the CDS may also default. CDS's played a role in the 2008 financial crisis, and now there are regulations in place to monitor and report all CDS transactions.
A more thorough explanation:
A credit default swap (CDS) is a type of financial contract where two parties exchange the risk that a credit instrument, such as a bond or loan, will go into default. The buyer of a CDS agrees to make periodic payments to the seller, and in exchange, the seller agrees to pay a lump sum to the buyer if the underlying credit instrument enters default.
Bob buys $1,000,000 in Blockbuster corporate bonds. He believes that the physical movie rental business is shrinking, and Blockbuster might declare bankruptcy soon and be unable to pay off the bonds he bought. Therefore, Bob purchases a CDS from a bank to cover the risk that Blockbuster defaults. In exchange for monthly premiums, the bank agrees to pay off the bond in the event that Blockbuster is unable to.
If Blockbuster defaults, Bob will receive the lump sum payment from the bank, which will cover the loss of his investment in the corporate bonds. If Blockbuster does not default, Bob will have paid the premiums for the CDS, but he will not receive any payment from the bank.
Credit default swaps can be used to mitigate risk, but they also carry risk in and of themselves. A CDS protects an investor from a third-party default but opens that investor up to the risk that the CDS seller itself will default. In this scenario, a party would lose not only the income from the underlying credit instrument which went into default, but they would also lose the money they paid in premiums to the CDS seller.
Credit default swaps played a large role in the financial crisis of 2008. In response, Congress passed the Dodd-Frank Act, which authorized the SEC and the CFTC to regulate the over-the-counter swaps market for securities, including CDS's. Current SEC regulations mandate that parties participating keep stringent records and report all CDS transactions.
Overall, a credit default swap is a financial contract that allows investors to protect themselves from the risk of a credit instrument going into default. However, it also carries its own risks and requires careful consideration before entering into such a contract.