# Explainer-What are credit default swaps and why are they causing trouble for Europe’s banks?
Author:  Pal Sinha, Barnali 
Author URL: https://financedigest.com/author/pal-sinha-barnali
Published: 2023-03-29
Category: NEWS
Category URL: https://financedigest.com/category/news
Meta Title: Credit Default Swaps in European Banks: Risks and Impact
Meta Description: Learn about the role of credit default swaps in banking turmoil, how they work, who buys them, and the potential impacts on the financial markets.
URL: https://financedigest.com/explainer-what-are-credit-default-swaps-and-why-are-they-causing-trouble-for-europes-bankshtml

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By Amanda Cooper

LONDON (Reuters) – Turbulence in Europe’s banks following the implosion of 167-year-old Credit Suisse and runs on regional banks in the U.S. has focused attention on the role played by credit default swaps in all the turmoil.

Investors, [worried about which bank](https://www.financedigest.com/boes-bailey-says-rate-setters-can-put-inflation-before-bank-worries.html "BoE’s Bailey says rate-setters can put inflation before bank worries") might be next, have hammered the shares and bonds of some of Europe’s best known banking names, including Deutsche Bank, Germany’s biggest lender.

The moves followed a surge in the cost of insuring Deutsche [Bank’s debt](https://www.financedigest.com/seven-out-of-ten-uk-adults-aged-25-44-never-seek-advice-on-dealing-with-debts-despite-depending-on-the-bank-of-mum-and-dad.html "Seven out of ten UK adults aged 25-44 never seek advice on dealing with debts despite depending on the bank of mum and dad") against default via credit default swaps (CDS) to a more than four-year high last week.

Andrea Enria, the banking supervisory chief at the European Central Bank, highlighted the volatility in Deutsche [Bank’s securities – including CDS – as a worrying sign of how easily investors](https://www.financedigest.com/stocks-rise-after-bank-sale-fuels-investor-risk-appetite.html "Stocks rise after bank sale fuels investor risk appetite") could be spooked.

There are markets like the single-name CDS market which are very opaque, very shallow and very illiquid, and with a few million (euros) the [fear spreads to the trillion-euro-assets banks](https://www.financedigest.com/banking-turmoil-means-recession-fears-are-creeping-back.html "Banking turmoil means recession fears are creeping back") and contaminates stock prices and also deposit outflows.

European banks [see default risk](https://www.financedigest.com/wto-sees-subpar-2023-trade-growth-with-multiple-risks.html "WTO sees “subpar” 2023 trade growth with multiple risks") costs soar, https://www.reuters.com/graphics/BANKS-CDS/jnvwyjrobvw/chart.png

WHAT IS A CDS ANYWAY?

Credit default swaps are derivatives that offer insurance against the risk of a bond issuer – such as a company, a bank or a [sovereign government – not paying their creditors](https://www.financedigest.com/sovereign-debtors-creditors-agree-on-steps-to-jumpstart-debt-restructurings.html "Sovereign debtors, creditors agree on steps to jumpstart debt restructurings").

Bond [investors hope to receive interest on their bonds and their money back](https://www.financedigest.com/glencore-courts-120-teck-investors-for-bid-backing-as-spinoff-vote-looms-source.html "Glencore courts 120 Teck investors for bid backing as spinoff vote looms -source") when the bond matures. But they have no guarantee either of these things will happen and so have to bear the risk of holding that debt.

CDS help to mitigate the risk by providing a form of insurance.

The CDS market is worth around $3.8 trillion, according to the International Swaps and Derivatives Association. But the market is well below the $33 trillion of its heyday in 2008, based on ISDA data.

The CDS [market is small relative to equities](https://www.financedigest.com/deutsche-bank-equity-bear-market-rally-will-stretch-into-2023-dollar-weaker.html "Deutsche Bank: Equity bear market rally will stretch into 2023, dollar weaker"), foreign exchange or the global bond markets, where there are more than $120 trillion bonds outstanding. Average daily volume in foreign exchange is close to $8 trillion, based on [Bank for International Settlements data](https://www.financedigest.com/reckon-introduces-link-to-bank-data-to-help-small-businesses-streamline-the-reconciliation-process.html "Reckon introduces link to bank data to help small businesses streamline the reconciliation process ").

Trading in these derivatives can be thin. The number of average daily CDS trades, even for large companies, can sometimes be in single digits, based on data from the Depositary Trust & [Clearing Corporation](https://www.financedigest.com/clearing-out-your-garage-benefiting-from-corporate-simplification-2.html "Clearing Out Your Garage – Benefiting from Corporate Simplification ") (DTCC).

This makes the market tricky to navigate and creates a situation where even a small CDS [trade can have an outsized price](https://www.financedigest.com/belgium-supports-energy-price-caps-suspending-trading-in-eu-power-crunch.html "Belgium supports energy price caps, suspending trading in EU power crunch") impact.

The [rise and fall of credit](https://www.financedigest.com/bank-shares-rise-after-credit-suisse-rescue-eases-crisis.html "Bank shares rise after Credit Suisse rescue eases crisis") default swaps, https://www.reuters.com/graphics/MARKETS-CDS/dwpkdkynovm/chart.png

WHO BUYS CDS?

Investors in bonds issued by companies, banks or governments can buy CDS insurance via an intermediary, often an [investment bank](https://www.financedigest.com/credit-agricole-launches-china-ma-and-investment-banking-business.html "Credit Agricole launches China M&A and investment banking business"), which finds a financial firm to issue an insurance policy on the bonds. These are “over-the-counter” [deals which do not go through a central clearing house](https://www.financedigest.com/us-house-committee-chair-concerned-by-tesla-deals-in-china.html "US House committee chair ‘concerned’ by Tesla deals in China").

The buyer of the CDS will pay a fee on a regular basis to their counterparty, which then takes on the risk. In return, the seller of the CDS pays out a certain amount if something goes wrong, just like an insurance payout.

CDS are quoted as a credit spread, which is the number of basis [points that the seller of the derivative charges](https://www.financedigest.com/germany-added-35-more-electric-car-charge-points-in-2022-says-bdew.html "Germany added 35% more electric car charge points in 2022, says BDEW") the buyer for providing protection. The [greater the perceived risk](https://www.financedigest.com/brexit-the-risks-to-the-city-and-fintech-have-never-been-greater.html "BREXIT: THE RISKS TO THE CITY AND FINTECH HAVE NEVER BEEN GREATER") of a credit event, the wider that spread becomes.

The owner of a CDS quoted at 100 basis points would have to pay $1 to insure every $100 of bonds that they hold.

Biggest CDS markets for corporate issuers, https://www.reuters.com/graphics/GLOBAL-CDS/lbvggjyyavq/chart.png

WHAT COULD TRIGGER CDS?

A CDS payout is triggered by a so-called credit event – which can include a bankruptcy of a debt issuer, or a failure to make a payment on bonds.

In 2014, a new category of credit event was introduced, so-called “Governmental Intervention”, to address investor concerns that CDS would not cover [measures taken by governments](https://www.financedigest.com/factbox-government-measures-to-ease-inflation-pain.html "Factbox: Government measures to ease inflation pain") to support struggling entities, especially banks.

Like any financial asset, CDSs are actively traded. If the perception of risk increases around a debt issuer, [demand for its CDS rises](https://www.financedigest.com/oil-rises-on-demand-hopes-as-banking-crisis-fears-subside.html "Oil rises on demand hopes as banking crisis fears subside"), widening the spread.

The biggest CDS market is for governments. Brazil tops the charts, with an daily notional average of $350 million [trades each day](https://www.financedigest.com/stocks-fall-treasury-yields-rise-upon-final-2022-trading-day.html "Stocks fall, Treasury yields rise upon final 2022 trading day"), based on DTCC data.

[Credit Suisse’s](https://www.financedigest.com/mitsubishi-ufj-to-postpone-at1-bond-issuance-in-credit-suisse-fallout.html "Mitsubishi UFJ to postpone AT1 bond issuance in Credit Suisse fallout") CDSs were the most actively traded on the corporate front in the last quarter of 2022, with $100 million traded each day, DTCC data shows.

[LEADING ROLE IN 2008 CRISIS](https://www.financedigest.com/new-pm-rishi-sunak-pledges-to-lead-britain-out-of-economic-crisis.html "New PM Rishi Sunak pledges to lead Britain out of economic crisis")

CDSs were one of the financial instruments at the [centre](https://www.financedigest.com/new-york-holds-top-spot-london-second-in-z-yen-financial-centre-survey.html "New York holds top spot, London second in Z/Yen financial centre survey") of the 2008 financial crisis.

Bear Stearns and Lehman Brothers were among the many [banks that issued CDS to investors on mortgage-backed securities](https://www.financedigest.com/digital-experience-and-security-the-crucial-combination-for-banks.html "Digital experience and security – the crucial combination for banks") (MBS) – mortgages bundled together into one package – among other types of derivative.

When U.S. interest rates rose sharply throughout 2007 this caused a wave of mortgage defaults, rendering billions of [dollars in MBS and other bundled securities](https://www.financedigest.com/incentive-fm-secures-new-deal-with-dollar-uk.html "Incentive FM Secures New Deal with Dollar UK") worthless. This triggered hefty CDS payouts for banks such as Lehman and Bear Stearns.

A REPEAT OF 2008?

No. A lot has changed since then. Many derivatives, including CDS, were far more widely used at that time and covered a broader range of assets, many of which went sour.

The current turmoil does not reflect a steep drop in the value of the securities that underlie the CDS. It is more the perception of risk, rather than actual risk.

In Deutsche Bank’s case, CDS on its five-year debt rose above 200 bps last week from 85 bps just two weeks ago, as investors fretted about the [stability of the broader European banking](https://www.financedigest.com/banking-stability-worries-go-behind-closed-doors-at-imf-world-bank-meetings.html "Banking stability worries go behind closed doors at IMF-World Bank meetings") system.

The ECB’s Enria argued that central clearing for CDS would improve transparency, reducing the risk of volatility.

Having these type of [markets centrally](https://www.financedigest.com/no-santa-rally-for-markets-as-central-banks-dampen-peak-rate-hopes.html "No Santa rally for markets as central banks dampen peak rate hopes") cleared rather than having OTC, opaque transactions … would already be a big progress,” he said.

(Reporting by Amanda Cooper and Karin Strohecker in [London and Davide Barbuscia in New York; Editing by Elisa Martinuzzi and Jane Merriman)](https://www.financedigest.com/new-york-catches-up-with-london-to-head-citys-global-centres-survey.html "New York catches up with London to head City’s global centres survey")


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