The Economics of Credit Default Swaps

Credit default swaps (CDSs) are term insurance contracts written on traded bonds. This review studies the economics of CDSs using the economics of insurance literature as a basis for analysis. It is alleged that trading in CDSs caused the 2007 credit crisis, and therefore trading CDSs is an evil that needs to be eliminated or controlled. In contrast, I argue that the trading of CDSs is welfare increasing because it facilitates a more optimal allocation of risks in the economy. To perform this function, however, the risk of the CDS seller's failure needs to be minimized. In this regard, government regulation imposing stricter collateral requirements and higher equity capital for CDS traders needs to be introduced.