Open AccessAre Credit Default Swaps Credit Default Insurances?
Author(s) -
Christian Schmaltz,
Periklis Thivaios
Publication year - 2014
Publication title -
journal of applied business research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.149
H-Index - 22
eISSN - 2157-8834
pISSN - 0892-7626
DOI - 10.19030/jabr.v30i6.8900
Subject(s) - credit default swap , business , credit risk , itraxx , actuarial science , credit derivative , cash flow , bond insurance , credit default swap index , insurance policy , finance , general insurance , auto insurance risk selection , credit reference , credit valuation adjustment
No, they are not. Although they exhibit similar cash flow patterns (economic perspective) this article argues that from a legal, accounting and regulatory perspective credit default swaps (CDS) are not considered to be an insurance contract. The protection buyer of a CDS is eligible to obtain the compensation without suffering any loss (and potentially realizing a gain) whereas insurance policies only pay out to compensate a loss (and not potentially realizing a gain). This disconnect between protection and exposure is the source for potential over-coverage. Furthermore, the concentrated set of reference entities and (interbank) counterparties as well as their tradeability make CDSs highly systemically significant products. Our conclusion is that CDSs are not default insurance policies. We propose to use default protection instead of credit default insurance to avoid the mislabelling. Furthermore, CDS have a substantial systemic risk potential which sharply contrasts to the limited systemic risk in the insurance industry. The legal classification of CDS as insurance contracts would have an enormous impact on the liquidity of CDS, as the ability of counterparties to issue and participate in CDS contracts would be limited.