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The difficulty of defining a default

Credit default swaps have proved a popular derivatives instrument with banks and other credit investors, but one possible trigger for default – the restructuring of a bond or loan – has cast uncertainty over the market. It is possible that liquidity might be damaged by the proliferation of different classes of instruments.

Glenn Barnes

It's not difficult to see why the market is so taken with credit default swaps. For the protection buyer, they are a quick and easy way for investors worried about a particular credit risk - whether originally taken on via bonds, loans, trade notes, or derivative counterparty exposure - to gain reassurance without having to dispose of assets. For sellers of protection, default swaps provide the opportunity to buy into sectors to which they may have little or no exposure, while avoiding the need to make a large capital investment up front. The buyer pays a premium to the seller in return for an agreement that, if a default occurs, the seller pays a sum equal to the value lost and assumes ownership of the defaulted assets.

For their part, dealers enthuse about being able to amalgamate limited liquidity in different parts of the market and convert it into a readily tradable instrument.

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