The History of the Credit Default Swap
Credit default swaps first appeared in the market past 2003 and emerged among the most well known financial instruments. Hullabaloo started during the financial disaster of 2007-2010 as AIG along with Lehman Brothers, the two major financial institutions, collapsed because they had invested heavily in credit default swaps.
As 1990 was nearing its end, credit default swaps were designed with the purpose of shifting risk, to which commercial banks were exposed for providing loans, to intermediary investors. These intermediaries were gaming that every loan would get defaulted because of which the banks and financial institutions would have additional capital. By the year 2000, the volume of CDS market stood at nearly one trillion dollars.
On entering into a credit swap accord, the purchaser offering ‘protection’ provides a string of funds to the seller. Should there be any default, repudiation or debt reconstruction, the purchaser collects a hefty payoff. Being financial instruments, the rules and regulations, as applicable in case of insurance companies, would not be valid for credit default swaps. Every swap needs conformity to rules framed by the International Swaps and Derivatives Association (ISDA).
Growth of CDS
The market for CDS experienced an exponential growth all through the first ten years of the current century. Trading of credit default swaps become very extensive, because of which uncertainly about the worth went high. Moreover, as none of the parties had provided funds against the original loan, level of speculation in the market went up. More than ten to fifteen parties could be implicated for trading of one CDS.
By 2007, the gap between structured and bond investments (25 trillion dollars) and CDS market (45 trillion dollars) reached the level of twenty trillion dollars. By the year end, the size of speculative ‘bubble’ had grown to 62 trillion dollars. Moreover, that very year was faced with the calamity of sub-prime mortgages, as a result of which the doubt about the evaluation of lending institutions and banks increased further. The market got knocked down to 38 trillion dollars in 2008. AIG and Lehman Brothers failed to pay, mainly because they had invested heavily in CDS.
Subsequent to the crisis
Following the financial disaster of 2008, it was realized that the CDS market, due its inadequate transparency coupled with its related connections could make an independent business like Lehman Brothers cause bigger financial collapse. Because of its complete exposure to risk and its size along with the absence of adequate laws, CDS market poses an exceptional danger to the firmness of financial system. The Trade Information Warehouse of the Depository Trust & Clearing Corporation (DTCC), in 2010, decided to allow the regulators an entrée to their registry of CDS.