Quora Answer: Are Investment Banks Still Trading in Credit Default Swaps?

The following is my answer to a Quora question: “Are investment banks still trading in credit default swaps?”

A credit default swap is a financial derivative.  It is contract that allows you to offset your credit risk with another entity. In essence, the lender buys a credit default swap, and the investor party agrees to reimburse the lender in the event of a default.  There is a premium to be paid, which makes the credit default swap function like a sort of insurance policy.

The structure of a credit default swap transfers the credit exposure of a fixed income product between multiple parties, spreading the risk.  The buyers of the swap make a series of regular payments to the seller until contract maturity.  In the event of a defaults or any another credit event, the seller agrees to pay the buyer at the security’s value, all interest payments, and other agreed costs due from the time of the start of the credit swap contract and the security's maturity date.

As can be seen, it is a necessary instrument for large contracts.  The parties involved need to spread the risk so that the default of a single large contract does not severely impact their liquidity.  Investment banks still trade in credit swaps, but they are limited by compliance regimes in the type of credit swaps and to limit speculation.  This means they have been forced to be more discerning about the underlying assets in these contracts.