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Credit default swaps: what are the social benefits and costs?

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Credit default swaps (CDSs) are derivative contracts that allow agents to shift the risk of default on an underlying credit from a credit protection buyer to a credit protection seller. Like other derivatives they are standardised relative to the underlying cash markets and in this way can help promote market liquidity. This in turn can facilitate risk shifting and price discovery. In this way they may lead to accurate pricing of credit risk and ultimately to the reduced costs of borrowing. However, like other derivatives it is possible that CDS contracts could play a part in market manipulations, especially when the underlying cash market is not transparent. This is a potential cost of CDS trading that should be weighed against potential benefits of liquidity, risk shifting and price discovery. We discuss the balance of these trade-offs in the context of singlename corporate CDSs, index CDSs, sovereign CDSs and CDSs on structured credit product tranches. We also discuss other potential costs of CDS trading including that they “make selling short too cheap” and that they may create market instability by facilitating speculative attacks.

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