Sovereign CDS Market: The Role of Dealers in Credit Events

A credit default swap (CDS) is a credit derivative that can be used as insurance against a reference entity’s credit risk, where a reference entity is either a government or corporation that has issued debt. It is formally a bilateral contract between a protection seller and protection buyer. The former is taking a short position in the CDS, while the latter is taking a long position. The protection seller compensates the protection buyer if there is a credit event with respect to any of the bonds issued by the contract’s reference entity. Credit events include bankruptcy, failure to pay, and restructuring, among other items. In exchange, the protection buyer makes periodic interest payments to the protection seller until the contract expires. As a result of their role in the 2008 financial crisis and in the sovereign debt crises in Europe, credit default swaps are among the most controversial derivative instruments. In both corporate and sovereign contexts, proponents of CDS attest to their beneficial effects in providing and transferring liquidity risk during times of distress. Critics view CDS as speculative bets, especially since CDS holders may hold more CDS than bonds with respect to the reference entity. That is, if a party owns equal amounts of bonds and CDS for a particular reference entity, then the party is completely insured against a negative credit event. In this way, a CDS works pretty much like an insurance policy on a car, house, or any other asset. However, unlike insurance, it is possible to own more CDS protection than the underlying bonds. As a result, CDS contracts make it possible to trade on