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.
- 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.
- 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.
- 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.
- 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 elses 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.
- 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.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Risk Management - Introduction
- Benefits of Risk Management
- Principles of Risk Management
- Risk Management Process
- Risk Identification and Assessment
- Aspects of Risk Management
- Steps in Risk Management Process
- Approaches to Risk Management
- Risk Management Policy
- Commonly Used Measures of Risk
- Risk Management Plan
- Evaluation of Risk Management Plan
- Risk Treatment
- Role of HRD in Risk Management
- Enterprise Risk Management
- Implementing ERM
- Risk Management and Stock Market
- Outsourcing Risk Management Program
- Risk Management as a Profession
- Anticipating and Mitigating Organizational Risks in the Digital Age
- Challenges Facing the Australian Economy
- The Economic Costs of MeToo
- Automated Claims Processing
- Challenges in Global Insurance And International Claims
- Conflicts of Interest in the Insurance Business
- The Cost Structure in the Insurance Industry
- How Drones Will Impact the Insurance Industry?
- How Is Health Insurance Funded?
- How Self Driving Cars Impact Insurance?
- How Stock Market Volatility Affects Insurance Companies?
- Insurance Agents vs. Insurance Brokers
- The ABCs of Insurance Fraud in India
- Technological Advances in the Insurance Industry
- The Basics of Unemployment Insurance
- The Pros and Cons of Unemployment Assistance and Why it Matters in the Present Times
- The Role of Insurance In #MeToo Movement
- Why the Flood Insurance Market should be Privatized?
- Basics of Pet Insurance
- Cannabis Insurance
- Challenges Facing Cryptocurrency Insurance
- Evolution of Insurance Regulation
- Food Delivery Apps and Insurance
- How Does Captive Insurance Work?
- On-Demand Insurance
- Reinsurance vs. Double Insurance
- Solvency Regulations in the Insurance Industry
- Terrorism and Insurance
- The Basics of Microinsurance
- The Basics of Reinsurance
- Types of Captive Insurance Companies
- What is P2P Insurance?
- How Risks Affect Companies Providing Financial Services
- Risk Management Information System
- Disadvantages of Risk Management Information Systems
- The Known-Unknown Classification of Risk
- Operational Risk: Definition and Drivers
- How Regulations Have Affected Operational Risk?
- Identification of Operational Risks
- How to Identify Operational Risks
- Using Internal Loss Data to Mitigate Operational Risks
- External Loss Data in Operational Risk Management
- Risk Control Self Assessment (RCSA)
- Scenario Analysis in Risk Management
- Key Risk Indicators
- Basel Approaches in Operational Risk Management
- The Basel Risk Categories
- Cause Categories in Operational Risk Management
- Loss Distribution Approach
- The COSO Framework for Internal Control
- Mistakes to be Avoided While Building a Risk Management System
- Credit Rating Terminology
- Types of Exposures to Determine Credit Limit
- Types of Credit Events
- Active Credit Portfolio Risk Management
- Metrics to Measure Credit Risk
- Credit Derivatives: An Introduction
- Credit Linked Note
- How do Credit Default Swaps Work?
- Why are Credit Default Swaps Dangerous?
- Total Returns Swap
- What are Collateralized Debt Obligations and How do they Work?
- Collateralized Debt Obligations: Advantages and Disadvantages
- Mark To Market Accounting
- What are Recovery Rates? - Different Types of Recovery Rates
- Netting, Close Out, and Acceleration
- Expected Default Frequency (EDF)
- Expected Default Frequency: Advantages and Disadvantages
- Altmans Z Score Model
- Unexpected Loss and Economic Capital Buffer
- Stress Testing in Credit Risk Management
- Provisioning in Credit Risk Management
- How Corporate Governance Impacts Credit Risk
- Exit Strategies In Credit Risk Management
- What is Market Risk? - How its Measured and Sources of Market Risk
- Why is Market Risk Management Important?
- Introduction to Value At Risk (VaR)
- The Three Types of Value at Risk (VaR)
- Marginal, Incremental and Component Value at Risk (VAR)
- How Value at Risk (VaR) is Implemented?
- Backtesting Value at Risk (VaR)
- Advantages of Using Value at Risk (VaR) Model
- Disadvantages of Using the Value at Risk (VaR) Model
- How Margins Are Calculated Using Value at Risk (VaR)
- Market Risk Limits
- Tail Risk
- The Upside of Market Volatility
- Relationship between Volatility and Risk
- Importance of Data Quality in Risk Management
- Impact of Using Poor Quality Data and Metrics to Measure Data Quality
- Enterprise Risk Management (ERM) vs Traditional Risk Management
- Benefits of Enterprise Risk Management
- Corporate Risk Governance
- International Risk Governance Committee (IRGC) Framework
- Failure of Market Risk Management
- Mistakes to Avoid in Risk Management