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Credit Default Swaps: An Overview of the Troubles They Pose for Europe’s Banks

Investors have been closely watching banks, especially after the collapse of Credit Suisse and the recent runs on regional banks in the US. This has brought attention to the role of credit default swaps (CDS) in the turmoil. Credit default swaps are derivatives that provide insurance against the risk of a bond issuer not being able to pay its creditors. These derivatives help to mitigate the risk by offering insurance. However, the CDS market can be volatile, as demonstrated by the surge in the cost of insuring Deutsche Bank’s debt against default to a more than four-year high. Andrea Enria, the banking supervisory chief at the European Central Bank, highlighted this volatility as a sign that investors can be easily spooked.

The CDS market is worth around $3.8 trillion, but is smaller than the $33 trillion market seen in 2008. The market can be difficult to navigate and thinly traded. The number of average daily CDS trades, even for large companies, can sometimes be in single digits. This creates a situation where even a small CDS trade can have an outsized price impact. However, ISDA reports that the market is now more transparent and that 83.4% of the total notional amount of CDS traded were cleared in 2022.

CDS are often bought by investors in bonds issued by companies, banks or governments. The buyer pays a fee on a regular basis to their counterparty, who then takes on the risk. In return, the seller of the CDS pays out a certain amount if something goes wrong. A CDS payout is triggered by a credit event, which can include a bankruptcy of a debt issuer or a failure to make a payment on bonds. The biggest CDS market is for governments, with Brazil topping the charts, with an average of $350 million trades each day.

CDS were one of the financial instruments at the centre of the 2008 financial crisis. Many banks, such as Bear Stearns and Lehman Brothers, issued CDS to investors on mortgage-backed securities and other types of derivative. When US interest rates rose sharply throughout 2007, this caused a wave of mortgage defaults, rendering billions of dollars in MBS and other bundled securities worthless, triggering hefty CDS payouts for banks such as Lehman and Bear Stearns. Many things have changed since then, and CDS are not expected to cause a repeat of the 2008 crisis.

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