CDS risks

Claims that credit derivatives were a major cause of the financial crisis have prompted regulators to threaten to clamp down on the market. In the latest in the current series of Class Notes, Charles Smithson examines some of the risks of credit default swaps

When it first appeared a decade and a half ago, the credit default swap (CDS) was a 'risk spreading' instrument. The impetus for the development of the CDS market was the need for banks to reduce credit concentrations. Insurance companies and other investors were willing to provide protection because CDSs offered cost-effective - and leveraged - exposure to loans and other bank-originated credit assets. However, the CDS market has changed dramatically in recent years. In 2006 and 2007, before