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.

Collateralized Debt 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 associated risks.

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 otherwise.

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