Definition
A credit default swap, or CDS, is a derivative contract that functions much like an insurance policy on a debt. One party, the protection buyer, makes regular payments to a protection seller. In return, the seller promises to compensate the buyer if a specified borrower defaults on its bonds or loans.
Although it behaves like insurance, a CDS is not regulated as insurance, and a buyer does not need to own the underlying debt. This allows market participants to bet on a borrower's creditworthiness without holding any of that borrower's bonds.
Why it matters
How it works
Suppose a bank holds bonds issued by a company and worries about default. It buys a CDS, paying a periodic premium called the spread. If the company defaults, the seller pays the bank for its loss; if not, the seller keeps the premiums as profit. The spread rises when markets judge the borrower riskier, so the contract doubles as a price signal. Trouble arises when sellers write far more protection than they can cover, concentrating risk in a few firms whose failure can cascade through the system.