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Future market giants: Why are financial giants so obsessed with CDS?
A credit default swap (CDS) is a financial derivative contract in which the seller will compensate the buyer if the borrower defaults or other credit events occur. This means that the seller of a CDS provides the buyer with an insurance arrangement against a specific asset or financial instrument. For financial giants, CDS is not only a risk management tool, but also a strategic tool for market investment and risk avoidance.
According to some reports, as of June 2018, there was still $8 trillion in notional value of CDS on the market.
History and Development of CDS Market
Since the early 1990s, CDS have rapidly gained widespread application in financial markets due to their flexibility and hedging capabilities. During the financial boom of the 2000s, CDS usage reached unprecedented levels. It fell from US$62.2 trillion at the end of 2007 to US$26.3 trillion in 2010, and then remained at US$25.5 trillion, showing the market's adjustment after the financial crisis.
The decentralized trading nature of CDS contracts raises greater transparency and systemic risk concerns in financial markets.
The operation and risks of CDS
CDS contracts involve two main parties: the buyer and the seller. The buyer pays a periodic premium, and the seller pays an agreed-upon compensation in the event of a default by the underlying entity (usually a company or government). It is worth noting that the buyer of CDS does not need to actually hold the underlying assets, which has led to the rise of "naked CDS". The market share of such contracts is as high as 80% to 90%.
In the CDS market, "naked CDS" have been criticized as being like insuring someone else's assets and may contribute to market instability, similar to buying fire insurance for your neighbor's house.
Diverse uses of CDS
The uses of CDS are quite flexible, including hedging risks, realizing arbitrage and speculation. In terms of hedging risks, investors can use CDS to transfer risks, while in terms of arbitrage, they can make profits by trading in different markets. At the same time, CDS also provide investors with the opportunity to speculate without actually holding the debt instrument.
Market transparency and future prospects
As the market expands, the transparency requirements for the CDS market continue to increase. Some financial regulators have begun requiring more detailed transaction data, but many challenges remain. The enthusiasm of financial giants for CDS may herald a fundamental change in the future market structure - a shift from the closed nature of the past to greater transparency and market supervision.
The size and complexity of financial markets make CDS a barometer of market health and an important tool for investors and regulators to monitor credit risk.
With the advancement of technology and changes in the financial environment, how will the future development of CDS affect the concept of global capital markets and risk management?
