Why are Credit Default Swaps Dangerous?

When credit default swaps first found their way into the global market, they were hailed as being a great invention. After all, they helped isolate the credit risk and helped investors use leverage to maximize their returns. It seemed like the most sensible thing to do and the end result seemed like a win-win deal with everyone earning a profit. However, it turned out that there were some negative issues related to credit default swaps as well. In this article, we will have a closer look at some of the shortcomings of the credit default swap.

1. Longer Tenure: Credit default swaps have one of the highest maturity for any derivative instrument. The average maturity for a credit default swap is 5 years. On the other hand, the average maturity for other derivatives instruments such as options and futures is not more than a few weeks. It is almost impossible to find any future or option with more than six months of liquidity and any meaningful liquidity.

   The long-term nature of the credit default swaps is a problem because a lot can change within five years. There might be a recession and even companies which had a stellar credit record before the recession might start defaulting on their debt. Hence, credit default swaps are extremely dangerous for companies that are selling the protection.

   Prior to 2008, the companies thought they were taking in risk-free money in the form of a premium. However, during the 2008 crisis, defaults became an everyday event, and sellers of protection had to book losses of millions of dollars every day! The credit default swaps almost ended up bankrupting AIG, which is one of the biggest insurance companies in the world.

2. No Regulation: Firstly, there is risk associated with these contracts since they are long-term.

   Secondly, there is virtually no oversight of these contracts. Companies that issue these contracts are not required to keep aside certain reserves.

   Also, in many countries, it is not even necessary to mark these contracts on the market. Therefore, the end result is that there are some players who sell more protection than they can afford to. This creates a chain of liabilities built on false confidence. Hence, if one party defaults, their counterparty also runs into cash flow problems and this sets off a systemic crisis.

3. Hidden Risk: Credit default swaps create hidden risks and flawed confidence in the markets. This is because the process of issuing credit default swaps is opaque and hidden from regulators. Also, it is common for sellers of CDS protection to themselves buy CDS from another party in order to hedge their risks.

   The chain of transactions is often long and complicated. In some countries, laws have been created mandating that the notional value of the contracts issued should be translated into bonds issued and shown on the balance sheet. This will help investors better understand the leverage inherent in the companies that they are investing in.

4. Naked CDSs: Probably, the most dangerous aspect of credit default swaps is what is commonly known as naked CDS. Naked CDS is a strategy wherein a person can obtain protection against a fall in the credit quality of another company without having any investments in that company! It is like taking insurance on someone else’s car! Now, it creates a situation wherein investors will benefit if there is a negative credit event at a certain company.

   There are many investment firms that specialize in such predatory investing. It is common for these firms to buy credit default swaps for these firms and also short their stock. Then, they use their financial muscle to purposely engineer a credit event. If that happens, these firms gain from the fall in the value of debt as well as equity.

   Credit default swaps give encouragement to such ecosystems which are built with the sole purpose of destroying the credit of other companies in order to earn a profit. The powers of structured finance start being put to destructive uses instead of being put to creative use.

5. Unrelated to Default Probabilities: Another problem with the credit default swap is that it becomes quite unrelated to the default probabilities over time. There are many other factors that decide the price of the contract.

   For instance, the liquidity of the contract, the credit rating of the company issuing the contract as well as the volatility associated with the contracts.

   Many times the price of the contract does not actually correlate to the movements in the underlying security. For instance, a 1% movement in the underlying security may create a less than 1% movement in the derivative contract. Thus it becomes a bad bet for people who are buying it to hedge the risk of an underlying contract.

Hence, credit default swaps have gained a very bad reputation over the years. This is why the investment charter of many companies explicitly prohibits them from trading in these derivative contracts. This is why other securities such as credit-linked notes have become popular.