Credit Default Swaps:
Navigating the cross-section with risk sharing

The market for Credit Default Swaps (CDS) has experienced explosive growth in the past. Credit default swaps have existed since the early 1990s and the market increased tremendously starting in 2003. By the end of 2007, the outstanding amount was $62.2 trillion, falling to $38.6 trillion by the end of 2008. The recent crisis has revealed several shortcomings in CDS market practices and structure.

In explaining CDS, the paper explains that they are a type of contract that offers a guarantee against the non-payment of a loan. In this agreement, the seller of the swap will pay the buyer in the case of a credit event (default) by a third-party. If no default occurs, the seller of the swap will have collected a premium from the buyer. Thus, this swap contract involves the buyer of a CDS making a series of payments to the seller and, in exchange, receives a payoff if a credit instrument – typically a bond or loan- goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur.

A CDS is the most highly utilised type of credit derivative. In its most basic terms, a CDS is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, investors buy credit default swaps for protection against a default, but these flexible instruments can be used in many ways to customize exposure to the credit market. CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, from one investor to another.

How does CDS work?

  1. Suppose that Company XYZ has lent money to in the form of a £1,000 bond.
  2. Company XYZ may then purchase a credit default swap from another company e.g. a Hedge Fund.
  3. If the firm ( default on the loan, then the hedge fund will pay Company XYZ the value of the loan.
  4. Thus, Company XYZ has insurance against loan default. The hedge fund has the opportunity to make a profit, so long as the firm does not default on the loan.
  5. The riskier the loan, the higher will be the premium required on buying a credit default swap.

Why use CDS?

A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. The second use is for speculators to “place their bets” about the credit quality of a particular reference entity. With the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. If a company’s financial position improves, the credit rating should also improve and therefore, the CDS spread should fall to reflect improved rating. This makes CDS more attractive to sell CDS protection. If the company position deteriorated, CDS protection would be more attractive to buy. Arbitrage could occur when dealers exploit any slowness of the market to respond to signals.

Shariah perspective

The paper outlines several reasons as to why CDS are non-compliant. There are multiple issues with CDS which breach Shariah principles and make CDS non-compliant financial instruments:

  1. Riba
  2. Maysir
  3. Gharar
  4. Trading an impermissible subject matter
  5. Prohibited form of debt trading
  6. Speculating on default

Shariah alternative

In describing an alternative to CDS, the paper takes a principled approach and states that an alternative to the current financial system must be founded on risk-sharing instead of risk-shifting as a basis for sustainable finance. In simple terms, credit default sharing is an agreement between cooperative banks for hedging default risk based on the principles of risk-sharing and Takaful, which means guaranteeing one another. Banks are the policyholders for protection. The paper proposes a model where in banks group together to develop a guaranty fund that represents all cooperative banks. Each bank should pay a variable sum of money in the form of a donation depending on the degree of risk in each bank’s portfolio (without recovery). The guaranty fund would function as a clearinghouse that becomes the counterparty to all trades. The fund can select credit (through a screening process), as well as diversify and manage the credit risk of the total credit portfolio through membership criteria based on minimum capital requirements for cooperative banks (in the form of a donation). The guaranty fund would prevents cooperative banks from facing additional exposures to the total credit portfolio and special margin calls depending on the degree of risk.