CDSs

CDS stands for credit default swap, a financial derivative used to transfer credit risk from one party to another. In a typical contract, a protection buyer pays a periodic premium to a protection seller in exchange for protection on a specified reference entity, such as a corporation or government. The contract has a notional amount and a defined term.

If a predefined credit event occurs—such as bankruptcy, failure to pay, or a debt restructuring—the protection seller compensates the protection buyer. The payoff is generally the notional amount minus the recovery value of the reference obligation, or a cash settlement equal to the loss, depending on the contract terms. The buyer of protection gains exposure to the reference entity’s credit risk without owning the debt, while the seller assumes that risk in exchange for the premium.

CDS contracts can be single-name or part of baskets or indices (for example, CDX or iTraxx). They are used for hedging against credit risk, trading perceived changes in credit quality, or expressing credit views. Trading is primarily over-the-counter, though standardized contracts and clearing have increased in many markets to reduce counterparty risk.

Regulation and market structure: after the 2008 financial crisis, many CDS markets adopted central clearing and enhanced disclosure to reduce systemic risk and improve transparency. CDS carry counterparty risk and liquidity risk, and their use can influence perceptions of credit risk and funding conditions in broader markets.

History: CDS were developed in the 1990s to manage credit exposure and rapidly grew into a major segment of modern credit markets.