How Credit Default Swaps Work, and How They Go Wrong

When credit default swaps are in the news, it’s usually a sign that something has gone haywire in the markets. These derivatives, known as CDS, are similar to insurance that pays out if a company or country defaults on its debt. Investors often use them as a hedge, because they offload default risk to a third party. CDS can also be used for speculation, to bet on a borrower melting down, for example. Warren Buffett once famously called these and other sophisticated derivatives “weapons of financial mass destruction,” foreshadowing the outsize role CDS linked to mortgages would play in the 2008-2009 financial crisis. A series of bank troubles in March sent lenders’ CDS surging, as more parties sought to protect themselves against the possibility of a financial company defaulting. Soon after, one CDS trade tied to Deutsche Bank triggered a global market selloff.

CDS are a type of derivative, which is a contract whose value is derived from price movements of an underlying financial asset, index or instrument. In this case, the value is tied to the risk that a company or country will default on its debt. A buyer of a credit default swap receives a payout from the seller if a borrower fails to make good on its obligations.