Are CDS responsible for financial crisis
and credit risk management?
The blame for CDS or
Credit Default Swaps is usually put on
the regulators, politicians as well as
the media. It is important to know the
actual purpose of CDS and what is their
contribution to the prevailing mayhem in
the economy. Credit default swaps are
simply credit derivatives. They are
financial instruments whose values
depend on the reference or underlying
assets like mortgage, bank loan, bond,
etc. A credit derivative enables a
financial institution to evade the risk
of loss due to occurrence of events like
ratings downgrades or bankruptcy.
Credit Default Swaps were
initiated in the 1990s by Wall Street as
a kind of insurance in opposition to
credit risks. CDS is simply an
arrangement between protection buyers
and protection sellers where a buyer
makes payments regularly as a substitute
for settling the credit loss with the
help of reference assets.
The popularity of CDS
increased rapidly as they were pretty
flexible but gave rise to complex
variations. One among them is the
default credit swap index, where the
average rate of a bond set is the
reference asset. These bond sets can be
selected from a particular sector of the
ratings class, economy or country.
Hence, the hedgers can get protection
from several assets at low costs.
Structured products –
After the exponential growth of CDS,
Wall Street was inspired to increase the
number of credit derivatives. The highly
complex credit derivatives are called
“structured credit products”. A
structured credit product is created
when financial institutions such as
banks acquire several risky assets.
After this, the cash flows are
distributed to investors via several
tranches or classes. These tranches then
get segregated by the credit risks. The
riskier tranches offers higher potential
return rate. This kind of structure
enhances the availability of choices to
investors who in turn can their credit
risk exposure with ease.
Obligation or CDO is one among the most
significant structure credit products.
Collateralized Debt Obligation is
generally backed with high-risk assets
like corporate bonds with low rates and
sub-prime mortgages. To increase value
of CDOs, an issuer could even sell the
protection via a CDS to an investor.
Despite the number of
benefits linked with CDS and card
derivatives, the truth is that these are
highly risky products for the buyers as
well as the sellers. They also have the
potential to cause catastrophic losses.
In order to increase profits
exponentially, several financial
institutions turned a blind eye to the
The fallout has led to
the call for reforms of the market of
credit derivatives. Several proposals
have been put forth so that credit
derivatives reformation could be done. A
few proposals have suggested
clearinghouse creation when will help in
reducing the counter-party risk as well
as increasing market transparency. The
usage of credit derivatives, including
CDS will be continued by institutions of
finance as a strategy for risk
management. CDS, when used correctly is
a powerful tool but causes havoc if used
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