The History of the Credit Default Swap
Credit Default Swaps emerged after 2003 as one of the most prominent financial instruments on the market. Controversy occurred during the 2007-to-2010 financial crisis, since Lehman Brothers and AIG, two collapsing financial institutions, were so heavily invested in Credit Default Swaps.
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Origin
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In the late 1990s, Credit Default Swaps (CDSs) were developed in order to shift the risk from commercial banks, which made the loans, to third-party investors. These third-party investors were betting that each of the loans would go into default, and the banks would then have more capital. The CDS market rose to almost $1 trillion by 2000.
Definition
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In a Credit Default Swap agreement, the buyer of "protection" gives a series of payments to the seller. In the case of a "credit event"--either a default, debt restructuring or repudiation--the buyer then receives a large payoff. Because Credit Default Swaps are a financial instrument, they are not subject to the same regulations that insurance companies are. Each swap requires a form regulated by the International Swaps and Derivatives Association (ISDA).
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Development
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The CDS market grew exponentially throughout the first decade of the 21st century. Credit Default Swaps were traded more widely, resulting in greater uncertainty about the value. Additionally, since neither party was invested in the original loan, the market faced a greater degree of speculation. Upwards of 10 to 16 parties cold be involved in the trading of a single CDS.
Crisis
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In 2007, a gap of $20 trillion separated the bond and structured investment vehicle market ($25 trillion) and the CDS market ($45 trillion). By the end of the year, a $62 trillion speculative "bubble" had formed in the CDS market. Additionally, the sub-prime mortgage crisis happened in the same year, sending the valuation of banks and lending institutions into greater uncertainty. In 2008, the market fell to $38 trillion. Lehman Brothers and AIG defaulted, largely as a result of their heavy investments in Credit Default Swaps.
After the Crisis
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After the 2008 financial crisis, the CDS market, with its interconnections and lack of transparency, was seen as one way that an individual business, such as Lehman Brothers, might cause a larger financial collapse. Due to the CDS market's systemic risk, size and lack of regulation, CDSs pose a unique threat to the stability of the financial system. In 2010, the Trade Information Warehouse of the Depository Trust & Clearing Corporation (DTCC) agreed to provide regulators with access to its registry of credit default swaps.
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