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.
Professors Cochrane, Diamond, Kashyap, and Rajan are part of the Squam Lake Working Group on Financial Regulation. Here is their latest memo on “Credit Default Swaps, Clearinghouses, and Exchanges” that analyzes the market for credit default swaps and makes specific recommendations about appropriate roles for clearinghouses and about how they should be organized.
