Credit Suisse CDS spike: What are credit default swaps? How they work, advantages and risks—Explained

Credit default swaps (CDS) Explainer: Credit Suisse, one of the world's largest banks, has recently been in the news for all the wrong reasons. The current financial health of the bank has worsened to the extent that experts and analysts have begun comparing it to the 2008 Lehman Brothers crisis — when the US-based bank had to file for bankruptcy. Panic gripped the global markets after Credit Suisse's five-year credit default swaps (CDS), which began the year at 57 bps, jumped 6 basis points to close at 247 bps on Friday, as per S&P Global Market Intelligence data. Let's have a look at credit default swaps meaning and how they affect an entity or a company... 

What is credit default swaps (CDS)?  

The credit which offers protection against default risk by a particular company is called CDS. Simply put, credit default swap is a type of insurance that protects a party against payment defaults. It is a contract between two parties—protection buyer and protection seller. It is a financial contract, whereby a buyer of corporate or sovereign debt in the form of bonds attempts to eliminate possible loss arising from default by the issuer of the bonds. The CDS is a tool to transfer and manage credit risk in an effective manner through redistribution of risk.  

Why and When CDS was introduced?  

It was introduced for leveraging portfolios, hedging, arbitration, and speculation. Credit default swaps were invented by JP Morgan in 1994. 

How CDS work?  

As most CDS contracts have a premium payment condition, a buyer can take risk control measures by shifting the risk to an insurance company in exchange for periodic payments. It is usually used by lenders to offset or swap the risk of defaulting by the borrowers.  

Advantages of CDS 

Apart from helping the buyer against the risk of non-payment by an entity, these swaps help the buyer to invest in riskier investments as the cost of such protection is very low.  

Risk With CDS 

The risk with CDS is that the buyer may default on the contract, causing a great deal of loss to the seller. The seller in this case will transfer the CDS to a third party, dropping the original buyer from the contract. However, the seller usually ends up incurring huge losses as he/she is forced to sell the new CDS at lower price. Besides, CDS risks comprise counterparty credit, operational, concentration, and jump-to-default risk.  

How CDS drives bankruptcy 

When a reference entity or a buyer fails to pay interest or principles, it drives the concerned party to file insolvency or bankruptcy due to its inability to pay the debt to the seller.  

What does Credit Suisse surge CDS means for global markets?  

Zee Business Managing Editor Anil Singhvi said, that for the first time, an event like Credit Suisse CDS hints at a probable recession. He said one needs to closely monitor the development around Credit Suisse as the stock of the bank had come down to $3.93 on last Friday from 12-month high of $10 

What does Credit Suisse crisis mean for Indian market?  

Even though the global markets are still to factor in the crisis surrounding Credit Suisse, V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, says the fears regarding the Credit Suisse crisis are unlikely to impact the markets since it doesn’t have the potential to become a systemic crisis.