One of the earliest signs of the financial crisis in summer 2007 was the plunge in the indices compiled from credit default swaps (CDSs) on a basket of subprime-backed bonds. Recently, the worsening situation in the emerging countries has been perceptible in the steep rise of CDS spreads on their sovereign bonds.
Credit default swaps protect investors against credit events on reference corporate or sovereign bonds. By guaranteeing against default risk, they also allow banks to reduce their equity requirements. In sum, CDSs are a hedging tool widely used by financial agents such as banks and hedge funds, which explains the CDS market's significant expansion in the past five years.
As in over-the-counter (OTC) markets, counterparty risk is high, for there is no CDS clearing house to underwrite commitments through a system of margin calls and collateral. The failure of a major player such as Lehman Brothers or AIG can thus aggravate systemic risk, although several procedures established by the International Swaps and Derivatives Association (ISDA) have, until now, proven their efficiency for unwinding CDS contracts.
The growth of CDSs helps lower banking systems' total equity requirements, as the reduction in the equity requirement for the CDS buyer (the protection buyer) exceeds the additional equity requirements incurred by the seller.
CDS premiums (spreads) serve to estimate default probabilities expected by markets and are thus a leading indicator of fears over the solvency of corporate or government borrowers. However, the direct use of CDS spreads to determine expected default rates is subject to several biases.