A credit default swap (CDS) is a derivative instrument used to transfer credit risk between two parties. This type of derivative is akin to an insurance policy, where a buyer pays an ongoing premium to the seller who agrees to make the payment of the security’s value and interest payments in case of a default.

CDS contracts generally involve the following parties:

• Counterparty A (the buyer) - seeks to transfer its exposure to the default risk of a specific security (often a corporate debt instrument) • Counterparty B (the seller) - agrees to accept the risk of any default • Referenced entity - the issuer of the security that is the subject of the transaction

The CDS market has grown significantly over the years, and in 2021, the estimated size of the CDS market in the U.S. was around $3.0 trillion. Credit default swaps have a variety of uses, which include speculation, hedging and/or arbitrage.

A famous example of the use of CDS is the role they played in both the 2008 Great Recession and 2010 European Sovereign Debt Crisis. During both events, large bets were placed that certain lenders would default on their debt. When an increase in defaults occurred, so did the CDS payouts, costing investors billions of dollars.

Overall, credit default swaps are an efficient way of managing the credit exposure of fixed income products, and can be used for a variety of purposes. Even though CDS has its dangers, it was also cited as one of the main reasons for the financial stability that followed the 2008 recession. CDS instruments are here to stay, and as such, investors must remain vigilant regarding the risks associated with their use.