Credit Default Swaps, Clearinghouses, and Exchanges

Overview

Credit default swaps (CDS) are contracts that provide protection against the risk of default by borrowers. The buyer of the CDS makes periodic payments to the seller, and in return the buyer will receive a payoff if the borrower defaults, analogous to an insurance contract. While credit default swaps can be a valuable tool for managing risk, they can also contribute to systemic risk. CDS contracts are currently traded over the counter rather than on exchange, raising concerns over counterparty risk. The failure of one important participant in the CDS market can destabilize the financial system by inflicting significant losses on many trading partners simultaneously. A clearinghouse could in theory reduce counterparty risk by standing between the buyer and seller of protection, insulating the counterparties’ exposure to each other’s default. This Working Paper, the fifth in the Squam Lake Working Group series distributed by the Center for Geoeconomic Studies, analyzes the market for credit default swaps and makes specific recommendations about appropriate roles for clearinghouses and about how they should be organized.