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Implications of CDS Credit Default Swaps basically evolved as a hedging technique against potential defaults.

But it can have serious implications if used as an instrument of speculation to bet against defaults. CDS are issued against sovereign debts and corporate debts. If mismanaged, both these types of CDS can have devastating consequences that have not gone unnoticed by the world of finance. As soon as Lehman Brothers announced its default in 2008, the claims against AIG substantially increased because it had issued tremendous amount of CDS to insure against default of Lehman Brothers. Though, AIG was finally saved from the brink of default by the U.S government, but the demise of the Lehman Brothers had raised many questions regarding the role of CDS and the regulation of the derivatives market. Financial analysts often question the issuance of CDS which is not backed up by sufficient capital and in case of default the seller of the CDS is therefore left with no money to pay for the default amount (as happened in the case of AIG). Moreover, issuance of CDS is often criticized because it enables the issuing company to reap huge benefits by pocketing premiums from the buyer of the protection. While in case of the default, the issuing company fails to pay colossal claims against CDS and thus needs to be bailed out by the money of tax payers, who were basically exempted from the profits that were originally made by the issuing company from the CDSs premium. Additionally the treatment of CDS as an off balance sheet item is recently raising a lot of brows with in the financial circles. The premiums that an issuing company receives against the CDS are recorded in the balance sheet as assets but no consideration is given to the cost (liabilities) that a company can bore in case of a default of the company, whose risk has been covered by the issuing company. Thus a huge chunk of risky investment is hidden from the public by not disclosing the amount of potential risk entailed with in a CDS.

The impact of sovereign debt CDS is far greater than corporate debt CDS. CDS issued to protect against sovereign debt default are often blamed for the ultimate default of countries. As soon as the spreads of sovereign debt CDS rise the demand for the CDS increases even more, consequently widening the spreads. The demand of CDS soars because large hedge funds start

betting on the default of the sovereign debts with the hope of making profits, thus they buy CDS excessively, transmitting a signal to the market that the country may default on its debts. This, in turn, raises the cost of borrowing for the country and also creates liquidity problems for it, as the demand for countrys bonds plunges considerably. Therefore, CDS is often blamed for the financial crisis in Greece specifically and in other euro zone countries such as Spain, Italy, Portugal, Iceland and Ireland. With response to this negative role of CDS rating agencies are also heavily criticized. They are often blamed for not acting with sufficient agility in terms of rating and their delayed response in terms of insurance companies and countries rating creates more room for the speculation.

But there is a counter view to this that says that charging CDS for the defaults is not prudent. Rather CDS actually act as a messenger that alerts the market about what is about to come, therefore CDS are not a cause of default but rather a warning of an upcoming default. They help to make the markets more efficient by giving information about the coming event through changes in their spreads. E.g. Greece is not failing on its sovereign debt due to high speculation on its CDS. But it failed because of continuous budget deficits due to which it was heavily indebted. Thus killing the messenger is not enough to tackle the euro crisis. Furthermore, CDS are cherished for credit expansion as countries or companies against whose debt CDS are issued find it increasingly convenient to raise debt. Thus CDS help in easing liquidity problems and also act as a vital source of information regarding the level of risk entailed in an investment. Despite its pros, currently questions are being raised regarding the regulation of CDS market and also about opening of a formal exchange where CDS can be traded in a standardized form and will be then be under regulation.

References http://books.google.com.pk/books?id=v0PIVvH0Py8C&printsec=frontcover&dq=credit+ default+swaps&hl=en&ei=hjHoTr7VDYS7hAeOvLj2Bw&sa=X&oi=book_result&ct=b ook-thumbnail&resnum=1 http://www.ft.com/cms/s/0/0589a94e-9d9f-11e0-9a7000144feabdc0.html#axzz1ghJ0wV3R http://www.isda.org/c_and_a/pdf/ISDA-AIGandCDS.pdf http://www.investopedia.com/articles/analyst/022002.asp#axzz1ghlfMKbO