A simple diagram showing how a credit default swap (CDS) works in a nutshell.
A credit default swap, or CDS, is a special kind of insurance for when you lend money out. Imagine you've lent your friend your favorite skateboard but you're worried they might not return it or might give it back all broken. A CDS is like making a deal with another friend that if your first friend doesn't give your skateboard back in good condition, this other friend will either give you a new skateboard or pay you the money to buy one.
In the finance world, rather than skateboards, it is more about loans or bonds, which are basically IOUs from companies or people for money they've borrowed. As a result, there's always a risk that they won't pay back this money. That's where a CDS comes in.
Here's how it works: one person, known as the "buyer," pays another person, the "seller," a little bit of money each year, kind of like insurance payments. In return, the seller agrees that if the borrower (the company or person) can't pay back their debt, they themselves will pay the buyer the amount that was supposed to be returned.
Now, the buyer of a CDS doesn't have to be the person who actually lent the money to the borrower. They can choose a random borrower and pretty much bet (by buying a CDS) that they will not pay back their debts, similar to betting on rain without owning a farm. Thus, if the borrower actually fails to pay back their debt, any person with a CDS on the borrower’s debts gets paid by the seller; if not, they've just paid those yearly fees for nothing.
The price of these yearly payments depends on how risky people think the borrower is. If everyone believes there's a bigger chance the borrower won't pay back, the fees go up, just like car insurance costs more for drivers who are more likely to crash.
Credit default swaps got a lot of attention during the 2008 financial crisis. Many people bought CDSs on bundles of home loans, betting that those loans might go bad. When lots of people couldn't pay their home loans, these bundles lost their value, and CDS buyers expected to get paid. But some of the sellers, like American International Group (AIG), didn't have enough money to cover everyone's claims, which caused a lot of problems because it meant that they couldn't fulfill their promises.
This showed that while CDSs are meant to manage risk, they can also make things riskier if not handled right. It's like having a safety net that tears if too many people jump on it at the same time. Because of this, there are now more rules to make sure everyone is safe if something goes wrong, ensuring that CDSs serve their purpose as a safety measure, not just a risky bet.