Credit Default Swap - Known as Financial weapon of mass destruction

Credit Default Swap - also called as "financial?weapons of mass destruction" by Warren Buffet. So what the product is, why its traded and what risk does it involve .

CDS product was introduced by JP Morgan in 90s and its traded in Over the Counter market. CDS is a like an insurance product that protects the Buyer of CDS on the default of the bond he has purchased. This insurance cover is provided by the Seller of the CDS for which the buyer pays a fixed amount on a regular basis. For example, if I have purchased bond for ABC company for $10 million . I fear that ABC will not pay me principal on the bond , so i can go to a Dealer of a CDS , ideally the Investment banks , if they can Sell me a protection on the bond on the default of ABC company and in return I would be pay a fixed amount on a regular basis .

To let you know, Its not necessary to hold the Bond to a Buy a CDS . A trader can also speculate on the credit risk of the underlyer creditability and enter into the contract and close of before maturity of the CDS if he wants.

During the 2008 crises, it was realized alot of Investment banks took so much risk on themselves by entering into Seller of a CDS with betting on the real estate of USA market, that they had legal obligation to pay Buyer of a CDS huge sum of money on the drop in real estate markets that triggered default of various reference entities. Seller of the CDS were betting that the real estate market wouldn't go down as the prices of real estate were increasing on regular basis during upto 2008.

Regulators identified this risk and ensured these are highly regulated and also cleared in the OTC world by standardization this product with having a standard rate at which a product must be traded, Settlement of coupon on 20th of every quarter , that is March, June, Sep and Dec and the effective and maturity date of the CDS falling on the same dates. This helped the investors, broker/dealers of CDS to closeout their position in a faster way, increase liquidity and also help to value the product in a better way along with its reporting which wasn't so efficiently done before standardization of the product.

CDS can be bought and sold on various reference entity bonds such as Municipal, Corporate, Sovereign , MBS and ABS , their tranches, Indexes and so on . ISDA has also setup a Determination Committee who identifies the credit events in the markets and formulates processes how the communication should be transmitted across in the markets until the settlement is done based on the Auction and recovery rate of the reference entity. The more risker or chances for the underlyer to default , higher the risk for the Seller . Reference entity are also categorized into grades such a Investment grades and Speculative based on which the Fixed rate of the CDS also gets determined when it comes to standardization.

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