Credit Default Swap (CDS) has, in less than a decade, gone from being an obscure financial engineering invention to one of today’s favourite large scale speculation tools. Hence the need to understand the operation and the central role of this instrument in the discussions of the crisis of the sovereign debt in Europe. In the case of CDS, any person or entity may acquire and transfer a CDS with no propriety relationship to the credit or the title linked to this financial instrument. This characterisitic of CDS has two consequences. Firstly, the difference between CDS and insurance and traditional financial derivatives permits CDS to evade the regulation of these sectors and converts them into a particularly opaque section on international financial markets. Secondly, the purchase or sale of positions on a financial asset which one does not own facilitates speculation for sums representing several times the value of the asset in question. This can be illlustrated with the collapse of subprimes in the United States.
Given that the CDS refer to the price of other financial contracts such as government debt securities, their value depends on what is called the recovery values of these contracts following the declaration of the credit event. This means that following the default a financial contract still has a certain value which depends on a possible law suit on the part of the speculators – most of them vulture funds - in order to recover part of the amount of the original loan. However, the price for this potentially exhorbitant profit from CDS is the risk they pose to the stability of the financial markets. Firstly, by allowing positions representing several times the value of the actual asset that they reference, CDS dramatically raise the losses associated with financial panic. Secondly, CDS and their insurance mechanism create the illusion of reducing risks. But in fact the losses resulting from a default are transferred to the entity that sold the protection in the form of CDS.
When all of this is taken into account, CDS should at best be eliminated from the financial markets entirely or at worst be subject to regulation as traditional insurance mechanisms. Such mechanisms would limit CDS to real positions in financial assets. Furthermore they would oblige entities active in the sale of such instruments to increase their reserves significantly in order to be able to cope with losses.