Imagine that you bought an asset--let us say a bond--whose future value was uncertain. If things turned out well, and the company made money, the bond would make you money. If things worked out badly however, the company would be unable to pay back its creditors and you would lose the value of your investment.
Not wanting to face this risk, you might want to buy insurance from someone else that protected the value of the bond in the event of the company defaulting on you. If things went well, you would have the value of the bond minus the insurance premium you paid. If things went badly, your insurance company would pay you the value of the bond. This insurance contract is what is called a credit-default swap.
Why call it a 'swap' then? Why not just call it insurance? The answer has to do with the drafting of the laws which governed the derivatives market following the commodity futures modernization act of 2000. When you call something insurance, it brings with it several regulations. Two regulations are critical here. First, there is a requirement that an insurance company has adequate capital to deal with an event where it needs to make payments. Second, the party buying the insurance must have an 'insurable interest'. That is to say , if I insure a house, I should own it, or have an interest in its being safe. Both of these are eminently sensible regulations. Clearly, one would not want a system where insurance companies cannot pay out to cover a fire burning down my house, nor would it be wise to allow me to insure my neighbor's house (since I would then have an incentive to damage it).
By calling the contracts swaps rather than insurance, the market could effectively circumvent these restrictions. Anyone could offer a contract to pay money in the case of any credit event (say the defaulting of a bond), and anyone could buy the contract for a specified payment. In effect, it became an unregulated market for gambling.
As a result, between 2000 and 2007, the credit default swap market grew enormously, reaching a peak of about 60 trillion dollars of outstanding contracts. Trouble began when the economy, and in particular housing, started to decline. Several large financial companies which had bought credit default swaps on their assets found that the one seller of these swaps--AIG--was going to be unable to pay and was in effect insolvent. The government--ostensibly in order to prevent a wholescale collapse of financial markets--took over AIG and decided to pay the full value of the contracts.
At the current juncture, there is no certainty about what to do with the CDS market. Most people think that reform is essential, and current proposals include everything from banning the products to regulating them like insurance products. What the government decides to do over the next few months will therefore be critical for the market.
Arjun Jayadev is an assistant professor of economics at the University of Massachusetts, Boston, and a visiting research fellow at the Columbia University Committee on Global Thought.