DEFINITION of Credit Default Contract

A credit default contract is a general term for securities with a risk level and pricing based on the risk of credit default by one or more underlying security issuers. Credit default contracts include credit default swaps (CDS), credit default index contracts, credit default options and credit default basket options. Credit default contracts are also used as part of the mechanism behind many collateralized debt obligations (CDOs); in these cases, the contracts may have unique covenants that exclude company events such as a debt restructuring as a credit event.

BREAKING DOWN Credit Default Contract

Credit default contracts establish a price for a given default risk, where it can then be traded to another party who wishes to accept it. For financial institutions, credit default contracts are a way to diversify credit risks by sharing them with the market. For companies and investors, a credit default contract can remove some of the risk of an asset without requiring the sale of that asset. For the speculators trading in credit default contracts without a stake in the underlying, these contracts offer a way to bet on credit ratings and profit from pricing mistakes in the market.

The Market Boom for Credit Default Contracts

Growth of credit default contracts exploded from the late 1990s to the early 2000s. The liquidity of these products and the ability to track reference entities and events improves as institutional investors piled in. They are a versatile tool for transferring risk away from a lender's balance sheet (such as in CDS) or for pure speculation by hedge funds and other investment vehicles. In fact, the situation reached a point where the outstanding credit default contracts on an underlying security were worth many times more than the value of the underlying.

Credit Default Contract Issues After the Financial Crisis

In addition to the breakneck growth in the size of the market, credit default contracts started to be gathered up into synthetic CDOs, allowing more unrecognized liability to build up in the system. The credit default contract market was shaken several times leading up to the financial crisis, but it finally blew up along with everything else after the Lehman Brothers collapse. The credit default contract market lost its unregulated status following the financial crisis and shrank to a tenth of the size in the following years.

Some structural issues still haunt the market for credit default contracts. Although these products are billed as insurance, they are in fact tradable instruments and are not as highly regulated as the insurance industry. A credit default contract seller could, for example, intervene on behalf of the reference entity or company to provide the financing necessary to avoid a credit event and there would be nothing overtly illegal about that. That said, the market is still useful for financial institutions and investors. It may not reach the heights it once enjoyed, but the credit default contract market will continue to operate.