What are Credit Default Swaps?

When trying to decipher the language of stockbrokers, it may come in handy to have a legal journal by your side. Many terms are variations of contracts, like a credit default swap. A credit default swap is a swap contract, constructed to allow the transfer of credit exposure of fixed income products between parties. On the surface, this may sound a bit like an insurance arrangement, but it is not. This investment is for the savvy investor to partake in. The parties entering this agreement agree to the basic terms: the buyer agrees to make payments to the seller in exchange for some type of credit tool – like a bond or a loan.

The reason that a credit swap seems like an insurance policy is for two reasons. The regularly scheduled payments are one factor, but most importantly it is the risk of default that is transferred – which seems to be very similar to insurance. However, it is done through parties and the holder of the fixed income trades security to the seller.

Ultimately a credit swap is a way for corporations to manage risk. The process is complicated and not for the novice investor. This complicated system actually made significant contributions to the credit crisis of 2008. The money involved in the credit swaps market is about double the amount in the stock market. Since the purpose of a credit swap is to cover losses on some securities in the event of a default the money flowing around is a factor that fed the fire of the economic crisis from a whole different angle.

The SEC does not regulate the credit swap market, so they have a completely different set of standards by which they have to operate.  Both the buyer and the seller can trade the commodities involved in the swap. Because it is not a regulated industry, the swaps can occur without anyone overseeing the trades to ensure the buyer has the resources to cover the losses to cover the possible defaults.